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LESSON 1 BUDGETING CONCEPTS

Information
(Feedback)

Organizations
(Hierarchies)

Planning Control

Management

Markets

Resources/
Money
EXTERNAL

Society/wants

State
1) Economic Problem
Human wants are unlimited but the resources to satisfy these wants are limited.
This creates the economic problem of matching scarce resources with unlimited
wants in order to optimize the returns.
2) State
The State is formed to govern the people and their resources. A State consists of a
nation and land. Nation includes all the people in a state and land includes all the
natural resources. State is also creates money which is a commodity generally
accepted as a medium of exchange and has a measure of value
3) Markets
The resources/money at the disposal of individuals are limited. Also the capacity
of resources to satisfy human wants is limited due to law of diminishing marginal
utility.. There arises a need for exchange. People give up what they possess
(resources/money at their disposal) to get what they need (goods and
services/Money). The exchange takes place in markets.
4) Organization
In modern society wants are satisfied through goods and services produced
through concerted efforts of people. An organization is necessary to bring together
people of diverse skills in order to process the resources into finished goods and
services. The skill level of people differs. Organizations are formed to pursue goals
that are achieved more efficiently by the concerted efforts of a group of people than
by individuals working alone. Business organizations produce goods/provide
services. Organizations get resources (human skills are also marketable resources)
from market, process the resources to produce goods and services. The goods and
services are put back in the market for sale. The returns are distributed amongst the
providers of resources. (Theory of exchange)
5) Management
Management involves getting people/resources together to accomplish desired
goals. Management involves planning, organizing, resourcing, leading or directing,
and controlling an organization (a group of one or more people or entities) or effort
for the purpose of accomplishing a goal. Management performs two functions-
Planning and Control
a. Planning
Involves choosing goals, predicting results under various ways of
achieving those goals, and selecting the best course of action to reach the
desired goals
b. Control
Involves
i. Action that implements the planning decision and
ii. Performance evaluation of the personnel and operations

6) Information system
Information system provides feedback to the management and all the other
entities regarding the outcome of management decisions and also relating to
environmental changes both within the organization and external to it. Feedback plays
a major role in managerial function. It involves managers examining past
performance and systematically exploring alternative ways to improve future
performance. Planning and control are two sides of same coin. Where planning ends
control begins and control forces managers to re-plan to correct deviations.

Organizations Add Value:

Data
Information System Information

Organizations-
Inputs Storage/Transformation/Conversion Outputs
Value

Plan/Control
Management
Organizations represent concerted efforts of people who can produce more through
joint efforts than by individual effort. Organizations add value to resources.
Organizations process input resources they get from markets, transform them to
outputs in form of goods and services. Value is added through
storage/transformation/conversion processes. Management guides and directs the
organization through planning and control. Information systems act as feedback
mechanisms guiding planning and control. Information systems also gather data from
outside and provide information to outsiders.

Functions of an Organization

Information System

FINANCE
INPUTS OUTPUTS
OPERATIONS

MARKETING

Plan/Control
Management

Basically an organizations perform 3 functions


• FINANCE: responsible for acquisition of resources
• OPERATIONS: responsible for conversion of input to outputs
• MARKETING: responsible for selling and distribution of outputs

There are of course other functions like accounting, information systems,


maintenance, record keeping etc. These act as support functions
(Source: Stevenson, 2006)

Information System

Cash inflow Cash outflow


FINANCE

INPUTS OPERATIONS OUTPUTS

Finished Goods Sales


MARKETING

Plan/Control
Management

The 3 functions INTERDEPENDENT NOT INDEPENDENT


• The purchase of inputs for OPERATIONS results in outflow of cash for
FINANCE function
• The output from OPERATIONS provides inputs of Finished goods for
MARKETING
• MARKETING closes the loop through Sales which results in Cash Inflow back to
the FINANCE
COORDINATION of the functions is another important task of management.
Value Chain:

Information System

Finance
Operation
s
R&D
INPUTS Design OUTPUTS
Production

Marketing
Marketing
Distribution
Customer
Services

Plan/Control
Management

Organizations add value to inputs to provide outputs. Value is added through efficient
operations and efficient marketing. The tasks an organization performs to add value to
resources constitutes its value chain. Value may be added through any of the activities on
the value chain. The Value chain activities include:
• Research and development(R &D): the generation and experimentation of ideas
resulting in creation of new products, services or processes
• Design of products, services, or processes- includes planning and engineering of
products, services or processes
• Production- involves coordination and assembly of resources to produce a product
or deliver a service
• Marketing- the process that enables individuals or groups (a) learn about products
or services and their value providing attributes (Advertising)(b) purchase those
products/services

Plan/Control
Management
• Distribution: the mechanism by which products or services are delivered to the
customer
• Customer service: the support activities provided to customers
(Source: Horngren, Foster, Datar (1996))

Management seeks information on all these value adding activities. The Management
Accounting/Information system collects and provides such information to the
management.
Accounting Information System

Accounting Information System


Financial-Cost-Management
Accounting Systems

FINANCE
INPUTS OUTPUTS
OPERATIONS

MARKETING

Plan/Control
Management /Coordination

Accounting Information System:


Accounting information system is the quantitative information system in any
organization. The system provides information for five broad purposes
• Purpose 1: Formulating overall strategies and long range plans: This includes new
product development, investment in both tangible and intangible assets
• Purpose 2: Resource allocation decisions such as product and customer emphasis
and pricing. This involves reports on profitability of products/services/brand
categories/customers/distribution channels etc
• Purpose 3: Cost planning and cost control of operations and activities: This
involves reports on revenues, costs, assets, and liabilities of divisions, plants, and
other areas of responsibility
• Purpose 4: Performance measurement and evaluation of people. This includes
comparisons of actual results with planned results.
• Purpose 5: Meeting external regulatory and legal reporting requirements:
Regulations and statutes prescribe the accounting methods to be followed. In USA
the reports must follow US GAAP prescribed by FASB. In India the Companies
Act provides the guidelines both for external reporting and cost reporting for
public companies.

Financial/Cost and Management Accounting Systems:


Management accounting measures and reports financial information as well as other
type of information to the managers in fulfilling the goals of the organization.
Management Accounting is not restricted by GAAP.
Financial accounting focuses on external reporting and is guided by GAAP. The
reporting is constrained by GAAP which prescribe the revenue and cost measurement
rules and types of items that are classified as assets, liabilities or equity in balance
sheets.
Cost Accounting measures and reports financial and other information related to
organization’s acquisition and consumption of resources. The information in cost
accounting system is used both by financial and management accounting. In India
Cost Accounting Record rules prescribe the cost accounting books to be maintained
in prescribed industries.
Cost Management:
Accounting systems help managers in Cost Management which involves actions by
the management to satisfy customers while continuously reducing and controlling
costs.

Managers as customers of Accounting:


Managers are becoming sensitive to providing quality and timeliness of
goods/services sold in the market. Managers therefore call for quality and timely
information. Accounting systems that provide quantifiable information must be aware
that managers are the customers of accounting and therefore must strive to provide
quality and timely information to the managers.

Overview of Management Accounting:

IV
I Cost Estimation
Standard Costs/Flexible and
Budgets/Activity Based Performance
Costs/Forecasts
Management Accounting System
Evaluation

II III
Budgeting Responsibility
Accounting/Cost
Accumulation/
Assignment

Cash inflow Cash outflow


FINANCE

INPUTS OUTPUTS
OPERATIONS

Finished Goods MARKETING Sales

Planning Control
Management /Coordination
Managerial Accounting is concerned with providing information to managers.
Management Accounting provides information to those inside the organization and who
are responsible for directing and controlling its operations/finance and marketing.
Managerial Accounting system provides support to the two fundamental managerial
functions viz Planning and Control.

A. PLANNING:
In planning, the manager outlines the steps to be taken to move the organization towards
its objectives. An organization prepares short term and long term plans. These plans serve
to coordinate, or weld together, the efforts of all the organization functions.

The process of planning involves:


1. Setting Goals and Objectives
2. Strategic Planning:
a) Deciding on what products to produce/or services to render
b) Deciding on the marketing and/or manufacturing methods to employ
c) Setting up organization policies
3. The work Management
a) Planning
b) Organizing and directing
c) Decision Making
4. Planning cycle has different phases:
a) Strategic plans concern senior managers and have longer time frame. They
deal with overall organizational goals and strategies
b) Intermediate plans concern middle level managers and deal with what
actions are necessary to implement the overall organizational strategy
c) Operational plans concern lower level managers and deal with day to day
routine activities and schedules
Managerial Accounting systems provide support to managerial planning through:
a) Standard Costs, Flexible Budgets, Activity Based Cost Drivers,
Forecasts(QUADRANT I)
Standard costs are predetermined costs that should be attained or incurred. Standard
Costs are useful in controlling direct materials and direct labor costs. Standards are set
after examining the production/operation processes and the tasks involved. An estimate
of future costs is made based on historical analysis, expert advice and insight. Standard
Costs serve two purposes:

Flexible Budgets are useful in controlling overheads. Overheads include indirect costs
which do not have a direct relationship with volume of output. However, overheads vary
with level of production activity. Within a particular level of production activity the
overheads may remain same. But overheads may differ at another level of output. A
flexible budget estimates overheads at different level of production.

Activity Based Costing approach focuses on activities as fundamental cost objects. An


activity is an event, task, or unit of work with a specified purpose. ABC uses cost driver
notion when allocating indirect costs or overheads. ABC costing approach requires a
thorough analysis of processes and preparation of “Activity Dictionary” in the planning
stage. The Activity Dictionary defines an activity and also its impact on costs. The
activities that influence costs are activity drivers. The cost drivers are very useful both in
budgeting and cost allocation. To cost any cost object, the activities involved in that cost
object are analyzed to identify the cost drivers. The cost of a cost object is determined by
applying appropriate cost rate for the identified cost drivers, using the Activity
Dictionary.

Forecasting is important for preparing sales budget. Forecasting acts as the starting point
for Revenue Budgets. Standard Costs, Flexible Budgets and Activity Based costs impact
help both Budgeting and Performance Appraisal.
b) Budgeting and Responsibility Accounting:( QUADRANT II)
A budget is a quantitative expression of a proposed future plan of action. It relates to a
particular set of time period. It acts as a blueprint for the organization to follow in the
budget time period. Budgets quantify management’s targets regarding future income,
cash flows, financial position. Budgets are projected financial statements. Budgets
include a budgeted income statement, budgeted cash flow statement, and budgeted
balance sheet.

Forecasts act as starting point of all the budgetary process. Forecasts help in preparing
revenue budgets.

In preparing Budgets, Standard Costs are used to estimate the direct costs of budgeted
activity (operations). Flexible Budgets provide an estimate of overheads for at a
particular level of budgeted activity.

Budgets are also useful as guideposts. Organizations actual performance is compared


with budgets to determine whether organization is lagging or exceeding expectations

B. CONTROL:
In Controlling, a management takes those steps that are necessary to ensure that every
part of the organization is functioning at maximum effectiveness and according to the
plans. To do this management studies the accounting and other reports, compares them
against plans set earlier. These comparisons show where operations are not proceeding
effectively, or where certain persons need help in carrying out their assigned duties.

Control, in large part, involves obtaining feedback on how well the organization is
moving toward its stated objectives. The feedback may suggest the need to replan, to set
new strategies, or to reshape the organizational structure.

Management Accounting System supports Control function through:


a) Responsibility Accounting, Cost Accumulation and Cost Assignment:
(QUADRANT III)

Responsibility accounting is a system that measures the plans (by budgets) and actions
(by actual results) for each responsibility center. In simple words, Budgets are prepared
for and Costs are collected and accumulated in relation to a Responsibility Center

The following terms are associated with Responsibility Accounting


1. Responsibility Center
2. Cost Center
3. Revenue Center
4. Profit Center
5. Investment Center

Cost Objects: To guide decision making, management is interested in knowing costs of a


certain thing. It may be a product, a new machine, a department etc. It must be something
for which a separate measurement of costs is desired. Cost Assignment is made to cost
objects.

Costs: Costs are the resources sacrificed or foregone to achieve a specific objective. Costs
are the amount of money expended for production of a good or service.

Cost Accumulation: Management Accounting system accumulates costs for cost objects.
The cost are accumulated through natural classification like materials, labor, fuel,
advertising, or shipping. The cost accumulation is done through Cost Accounting
system.

Cost Assignment: Costs are assigned to cost objects. Costs are assigned through
1. Cost Tracing
2. Cost Allocation
Direct costs of a cost object can be directly traced to the particular cost object
Indirect costs of a cost objects cannot be so traced but has to be allocated using a cost
allocation method.

The terms cost tracing and cost allocation are usually used with reference to historic
costs.

Cost Accumulation and Cost Assignment help Cost Estimation and Performance
measurement.

b) Cost Estimation and Performance Measurement: (QUADRANT IV)


Cost estimation is required to be made for managerial control purposes and also for
pricing. For control purposes historic costs have lesser value. Managerial decisions
impact future actions and such decisions invariable require estimations.

Estimation of costs are made based using different costing techniques like Normal
Costing, ABC Costing, Standard Costing etc.

Performance measurement involves comparison of actual costs with predetermined costs.


Actual costs are compared with Standard Costs, Flexible budgets and Activity Based
estimates to determine any variance. Performance measurement directly helps Control
function of management.

The end result of Performance Measurement is creation of variance reports which gives a
measure for the deviation of actual cost from planned costs. This facilitates managerial
control function. Managers inquire into the reasons for deviations and take corrective
action. If needed they may re-plan or even set up new standards/budgets.

1) Budget is a formal quantification of Management plans:


1. An organization has goals. Plans are formulated to reach the goals.
2. Plans specify the resources to be allocated and expected results
3. A Budget is a detailed written expression of an entity’s expectations with respect
to acquisition and use of resources for a specified period of time
4. A budget is a management tool. It is a quantitative statement of an
organizations plan of action for a specified period.
5. A budget is a quantitative expression, for a time period of a proposal of future
plan of action(Horngren).
6. Budget can cover both financial and non financial aspects of plans and acts as
blueprint for the organization to follow in the specified time period.
7. Budgets quantify management’s expectations regarding future income, cash
flows, and financial position.
8. Budgets prepare financial statements for future periods covering budgeted income
statement, a budgeted cash flow statement and a budgeted balance sheet.
9. Budgets are not only means of communicating management plans to the
organization but also provide a basis for evaluating segment and organization
performance by providing yardsticks against which actual performance could be
compared
2) Budgets touch every aspect of an organizations functioning. Budgets are prepared for
all the functions of the organization as illustrated below:
I
Std Costs/ABC/ IV
Performance
Flexible Budgets
Measurement/
/Forecasts Accounting
Management Cost Estimation
System
II III
Budgeting Responsibility
Accounting/Cost
Accumulation
Cash outflow
FINANCE
Cash inflow Capital Budget
Cash Budget
Budgeted Income Statement
Budgeted B/s/ cash Flow
OUTPUTS
INPUTS Sales
OPERATIONS
Production Budget
Finished Goods DM Budget
DL Budget
MOH Budget

MARKETING
Sales Budget
Selling/distribution OH Budget

Planning Control
Management /Coordination

3) Purpose of Budgeting:
1. Forces Planning: Budgets force managers to plan ahead for the activities of the
organization. The budgeting process compels managers at every level in the
organization, from chairman of the board to departmental supervisor to plan.
Budget is most useful when done as part of organization’s strategic analysis. In a
strategic analysis management considers how an organization can best combine
its own capabilities with opportunities available in the market to accomplish
overall objectives.
Strategic planning considers questions like:
1. What are the overall objectives of the organization?
2. What are the markets for the products, market segments, trends
in the market, product differentiation, market niche etc? How is
the organization affected by the economy- different rates like:
prices, wages, interest, foreign exchange etc?
3. Organizational forms and financial structures that suit the
accomplishment of strategy?
4. Alternative strategies and risks associated therewith
2. Facilitate Communication and Coordination: The budgeting process requires that
managers of different departments or divisions communicate about the plans they
have made. Also budgets provide GOAL CONGRUENCE and facilitate
COORDINATION of activities
Coordination is the meshing and balancing of all factors of production or services
and of all the departments and business functions so that the company can meet its
objectives. Communication is getting those objectives understood and accepted by
all departments and functions.
Coordination and communication go hand in hand.
Budgets provide a means for communicating plans. Also through a master budget
each department knows the plans of other departments. Production manager
knows sales plan, purchasing manager knows of production plan, finance manager
knows about operations plan etc. This facilitates coordination
3. Allocate Resources: Organizations have goals for market share, growth, dividend
payout etc. Non profit organizations may have social goals. Organizational plans
allocate resources and specify expectations. A budget specifies the expectations in
specific terms.
4. Evaluate Performance and Provide Incentives: Performance assessment: Budgets
act as guideposts for assessing success or failure of individual manages and
functional areas. Actual revenues, expenses, costs and other metrics are compared
with budgets to determine whether there is a lag or lead.
Budgeted performance measures are better than using past performance as a
means for judging actual results. Past performance may sometimes be below par
or substandard so may not be suitable for comparison of present performance.
Also performance expected in future may be different than what happened in past
because of changed circumstances and markets.
Budgets are prepared using standard costs and standard data. Also Budgets take
into account any expected changes because they are prepared within the
framework of organizations strategic plans. Budgets provide better measures for
performance assessment.
5. Provide Control: Initially a budget is a planning tool, but it is also useful as a
controlling tool. Comparison of actual performance with budgets highlights
variances. Analyses of variances reveal measures to be taken for better utilization
of organizations resources.

4) Factors Influencing Budgeting process:


1. Organization’s strategy and internal environment
2. Industry situation: market share, governmental control, labor market, competitors
etc
5) Features of a successful budgeting process:
1. Sufficient lead time: Must commence with fiscal year. It takes months of
preparation before a budget becomes final
2. Budget planning calendar: Budgets are prepared for every function in the
organization. Also the budgets are interdependent. So the whole budgeting
process needs to be coordinated through a budget planning calendar that shows
the schedule of activities to be carried on for development of the budgets. It
specified when information is to be provided to others by each information source
3. Budget Manual: Prescribes detailed procedures for preparing the budget.
Prescribes standard forms to be used by departments to prepare budgets. Also
specified ultimate goals and baseline assumptions. Also budgets are
interdependent. Budget manuals outline distribution instructions necessary to
coordinate interdependencies
4. Participation: Participative budgeting is necessary to ensure proper
implementation. The top management consisting of board of directors lay down
the mission. The senior management translates missions to strategic plans and
measurable, realizable goals. A Budget committee drafts budget manual and
budget calendar. Middle and lower management receive budget instructions, and
draw up the departmental budgets.
6) Use of Cost Standards:
1. Standard costs are predetermined expectations of how much a unit of input,
output or an activity should cost
2. Standard costs are based on accounting, engineering or statistical quality control
studies
7) Activity Analysis:
1. Activity analysis is necessary to prepare activity based budgets
2. Activity analysis identifies, describes, and evaluates the activities that go into
producing a particular output
3. Activity dictionaries are prepared to describe different types of activities carried
on in an organization
4. The descriptions given in activity dictionary are used to identify the activities
involved in an operation
5. Historical data may be used to determine the cost of performing an activity
6. Budgets are prepared based on the activity costs involved in budgeted
operation/department/function
8) Time frame for Budgets:
1. The time frame for budgets differs according to the nature of the plan
2. Strategic plans and budgets involve longer time frames
3. Intermediate plans and budgets have time frame of up to 2 years
4. Operational plans and budgets have time frames of 1 month to 1 year
9) Management by Objectives:
1. Management by objectives is often used in conjunction with a budgeting process
2. Under this approach, the organization’s mission or primary goal is broken down
into specific objectives.
3. Budgets are then developed to meet each of these objectives.
10) Budget Behavioral Considerations:
1. Budgets are effective in some organizations and in some organizations, because of
the differences in the attitudes of lower level management and other affected
personnel toward budget
2. Budgets must be prepared to encourage employee behavior that promotes best
interests of the total organization
3. Budgets must be developed with active participation of all concerned
4. Managers must be discouraged from slacking or padding:
i) Sometimes managers may give highly conservative budgets in order to avoid
challenges.
ii) Padding the budget or introducing budgetary slack refers to the practice of
underestimating budgeted revenues in order to make budgeted targets easily
achievable.
iii) This happens often where managers are rewarded for performance.
iv) Also budgetary slack hedges marketing managers against adverse
circumstances.
v) There are also pressures on managers to overestimate the revenues while
preparing budgets. Overstated revenues results in challenge revenue budget.
Sometimes organizations use challenge budgets as motivational tools for
managers to work toward a challenge target which requires above average
effort
11) Budget Administration:
1. Employee resistance to budgeting program may be overcome with top
management support and proper administration of budget
2. An effective administrative framework should be established for successful
implementation and follow up of budgeting programs
3. Approaches to Budgeting may be Top Down where budgeting is done at the Top
and then disaggregated to units and sub-units. The disadvantage of this approach
is it may not evoke employee participation
4. In Bottom Up approach the budgeting is done at subunit/unit level and then
aggregated to an overall organization budget. At the subunit/unit level the goals of
the overall organization may not be understood which may result in lack of goal
congruence
5. Line managers should have the primary responsibility for development of
individual components of the budgets. But there is a need for technically
competent individual to provide assistance and to assume responsibility for
formalization of overall budget
6. A Budget Director is appointed to administer the program and coordinate the
different phases of the program