Background Readings

Budgetary Controls
(Concepts & Application)

A] CIMA definition of budget

A plan quantified in monetary terms prepared and approved prior to a defined period of time,
usually showing planned income to be generated and/or expenditure to be incurred during the
period coupled with the capital to be employed to attain the given objective is called a
budged.

B] Brown and Howard definition of budget

A budget is a predetermined statement of management policy during a given period which
provides a standard for comparison with the results actually achieved.

C] Characteristic features of budget

a) A budget is primarily a planning and control device.
b) Usually prepared in monetary and quantitative terms.
c) Prepared for a definite future period.
d) The primary purpose of the budget is to implement the policies formulated by
management for attaining the given objective.

D] CIMA definition of budgetary control

Budgetary control is the establishment of budgets relating to the responsibilities of executives
in respect of management policies and the continuous comparison of the actual outcome with
the budgeted results, either to secure by individual actions the objective of the policy or to
provide for a basis for its revision.

E] The canons of budgetary control

Based on the above definition, the primary features of budgetary control can be summarized
as under:
a) Establishment of budgets for each function/department of the organization.
b) Compare actual performance with the budget on a continuous basis.
c) Analysing the variances [budget vis-à-vis actual]
d) Taking suitable remedial actions wherever necessary.

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 e) Revision of budgets in view of changes in the relevant conditions affecting the
budget.

The technique of budgetary control is now widely used in the business world. Many
businesses fail because of lack of efficient planning which could have reflected the inherent
weaknesses and could also have highlighted the challenges ahead.

F] Forecast is not a budget

A forecast is a prediction of what may happen as a result of a given set of circumstances. It is
basically an assessment of probable future events.
A budget, on the other hand, is a planned exercise to achieve a target. Forecasting thus
precedes the preparation of a budget.
Thus forecast is concerned with probable events, while budget relates to planned events.
Budget, being related to the objective of an enterprise can be only constructed by the
authorized management.

G] Objectives of budgetary control

Planning A budget detailed plan of action for a business over a period

of time. By planning many problems are anticipated long
before they arise and solutions can be sought through
careful study.

Coordination Budgeting aids managers in coordinating their efforts as a

whole harmonizes with the objectives of its divisions.

Communication A budget is an essential device for communication. The

approved budget is usually distributed to all management
personnel which provides not only adequate knowledge and
understanding of the business policies, but also highlights
the restrictions to be adhered to.

Motivation A budget is a useful device for motivating managers to

perform in line with the company objectives.

Control There is no denying the fact that budgets can be effectively

utilized as a primary control device.

Performance Evaluation A budget provides a useful means of informing the

managers how well they are performing in meeting targets
they have preciously helped to set.

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H] Advantages of budgetary control
a) It compels the managers to think ahead.
b) Coordinates activities of various functions and departments.
c) It may increase efficiency, eliminate wastes and may act as an effective cost
control measure.
d) Provides a yardstick against which actual results can be compared.
e) It shows the management the specific areas warranting immediate actions.
f) Identifies efficient operations as against unsuccessful ventures.
g) It may direct funding in more profitable ventures.
h) It may assist in delegation of authority and assignment of responsibilities.

I] Limitations of budgetary control

The list of advantages given above is quite impressive but it must be borne in mind that it is
not a cure for all ills. Management and employees of any organization should also be aware
of the inherent limitations of the same.
a) The budget plan is based primarily on estimates and forecast.
b) Budgets which are not revised periodically cannot be treated as dynamic and the evils
of rigidity might creep in.
c) Budgets should not be regarded as a master but as a servant. It is only a tool of the
management and the employees should not treat it as a bottleneck in terms of their
day-to-day performance.

J] Essential of effective budgeting mechanism

a) No control system can be effective unless the top management considers the system
to be important. In other words it requires support of top management.
b) Those entrusted with the responsibilities of performing as per the budget must be
involved in its construction.
c) The goals set must be reasonable and achievable.
d) Various aspects may be clearly defined and the budget must be prepared in a
transparent manner. Scope of ambiguity and alternative interpretation may be
avoided at all costs.
e) An adequate accounting system should be in place to support the preparation and
evaluation of budgets.

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K] Essentials for installing an effective budgeting mechanism

Creation of Budget Budget centres must be clearly defined because a separate

Centres budget has to be constructed for each of such centres with the
aid of the respective departmental heads.

Introduction of Adequate The accounting system should be designed so as to enable

Accounting Records record maintenance, providing information and analyze the
information so required.

Preparation of An organization chart should be prepared which clearly shows

Organizational Chart the organizational plan. Each member of the management
should know the exact scope of his authority and responsibility
of his relationship with the other members of the group.

Establishment of Budget In big organizations, the direction and execution of the budget
Committee is delegated to a budget committee which reports directly to the
top management. The finance controller is usually appointed as
the director of the said committee. He is in charge of
preparation of budget manual instructions and accumulates the
budget and actual figures for reporting purposes. Other
members of the said committee usually comprise of various
functional and department heads.

Preparation of Budget A budget manual has been defined by CIMA as a document

manual which sets out the responsibilities for the persons engaged in
the routine activity of the organization and who are directly
responsible for maintenance of the records and providing
information for budgetary control exercise.

Budget Period Budget period is a length of time for which the budget is
prepared. Budget periods vary between short term and long
term and no specific period can be laid down for all budgets.
But, it is interesting to note that budget period must be specified
for each and every budget. Otherwise the budget loses its
relevance and importance altogether.

Determination of Key Key factor is defined as the factor, the extent of whose
Factor influence must first be assessed in order to ensure fulfilment of
the basic objectives of the budget. The key factor serves as the
starting point for preparation of any budget. For instance when

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 sales potential is limited, sales is the key factor. Thus the sales
budget should be prepared first. Other budgets should be
drafted in unison with the sales budget.

L] Master Budget
When all functional budgets have been prepared, these are summarized into what is known as
a master budget. Thus, a master budget is a consolidated summary of all the functional
budgets. According to CIMA, master budget is a summary budget incorporating its
component functional budgets and which is finally approved, adopted and employed.
A master budget can be essentially classified into two aspects:
a) Operating budget or a budgeted profit and loss account.
b) Financial budget or a budgeted balance sheet.

M] Fixed Budget
A fixed budget is one which is prepared keeping in mind one level of output. It is defined as
one which is designed to remain unchanged irrespective of the level of activity attained. If
actual output differs from budgeted level of output, variances will arise. Fixed budget is
prepared on the assumption that output and sales can be estimated with a fair degree of
accuracy. This means that in those situations where sales and output cannot be accurately
estimated fixed budget is not considered suitable.

N] Flexible budget
In contrast to fixed budget, a flexible budget is one which is designed to change in relation to
the level of activity attained. The underlying principle of flexible budget is that a budget is of
little use unless cost and revenue are related to the actual volume of production. Flexible
budgeting has been developed with the objective of changing the budget figures to
correspond with the actual output received. Thus a budget might be prepared for various
levels of activity say 70%, 80%, 90% and 100% capacity utilization. Then whatever is the
level of output actually achieved, it can be compared with the appropriate level. Flexible
budgets are usually prepared in those companies where it is extremely difficult to forecast
output and sales.
The figures in flexible budgets are adaptable to any given set of operating conditions. It is,
therefore, more realistic than a fixed budget which is true in only one set of operating
conditions. In brief, it is more realistic, practical and useful.

O] Budget reports
Establishing budgets in itself is of no use unless there is a continuous flow of budget reports
showing comparison of action and budget figures. Budget reports should be prepared at

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regular intervals {say, every month} showing the reasons for the differences (i.e. variances)
between actual and budgeted figures. The reports should be structured and drafted in such a
way so that it establishes the responsibility for variances. Reports should also indicate whether the
variances are adverse or favourable and whether those are controllable or uncontrollable.

The budget reports should be simple and suitable for the level of understanding of the users and
should be presented promptly and figures presented must be accurate. Redundant and irrelevant
information should never be provided in the budget report.

A standard format of a user friendly budget report is presented below for your ready reference:

Budget Report

Budget Centre ………. ….. Period………………

Code No Items of Budgeted Actual Adverse Favourable Remarks

Expenses [Rs.] [Rs.] Variance Variance
[Rs.] [Rs.]

P] Zero-base budgeting [ZBB]

Before preparing a budget, a base is determined form which the budget process begins. Quite often
current year’s budget is taken as the base or the starting point for preparing next year’s budget. The
figures in the base are changed as per the plan for the next year. This approach for preparing a budget
is called incremental budgeting since the budget process is concerned mainly with the increases or
changes in the operations that are likely to occur during the budget period. The main drawback of this
approach is that is perpetuates the past inefficiencies.

ZBB is an alternative to incremental budgeting. ZBB was introduced at Texas Instruments in USA in
1969 by Peter Phyrr, who is known as the father of ZBB. It is a managerial tool and is steadily
gaining acceptance in the business community. ZBB is not based on incremental approach and
precious year’s figures are not taken as the base for preparing next year’s budget. Instead the budget
figures are developed with zero as base, which means that a budget will be prepare as if it is being
prepared for a new company for the first time.

Peter Phyrr has defined ZBB as a planning and budgeting process which requires each manager to
justify his entire budget request in detail from scratch [hence the name zero base]. Each manager
should start why he should spend any money at all. This approach requires that all activities by
identified as decision packages which will be evaluated by systematic analysis ranked in order of
importance.

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It is also defined as a system whereby each budget item, regardless of whether it is new or existing,
must be justified in its entirety each time a new budget is prepared. Novel part of the ZBB is the
requirement that the budgeting process starts from zero point with all expenditures fully justified.
This contrasts with the usual approach where a certain level of expenditure is allowed as a starting
point and the budgeting process focuses or stresses on the requests for incremental expenditures.

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 BUDGET SLACK
(Clarifying the Concept)
Conceptually, budgeting is most effective when lower-level managers actively participate and
meaningfully engage in the budgeting process. Participation adds credibility to the budgeting
process and makes employees more committed and accountable for adhering to the budget.
But, participation requires “honest” communication about the business from subordinates and
lower- level managers to their bosses.

At times, subordinates may try to “play games “and build in (what is called) - “budgetary
slack”. Budgetary slack is the practice of underestimating budgeted revenues or
overestimating budgeted costs to make budgeted targets more easily achievable. This practice
frequently occurs when budget variances (actual vis-a-vis budget amounts) are used to
evaluate the performance of line managers and their subordinates.

Budgetary slack provides managers with a hedge against unexpected adverse circumstances,
but, budgetary slack also misleads top management about the true profit earning potential of
the company which in turn may lead to inefficient resource planning / allocation and poor
coordination of various activities.

To avoid problems of budgetary slack, some companies use budgets primarily for planning
and to a lesser extent for performance evaluation. They tend to evaluate performance using
multiple indicators that take into account various other factors as well (rather than restricting
such evaluation to budget variances parameters ONLY).

MANAGEMENT BY EXCEPTION
(Clarifying the Concept)
Variances bring together the planning and control functions of management and facilitate
“management by exception”. Management by Exception is a practice whereby managers
focus more closely on areas that are not operating as expected and less closely on areas that
are. Sometimes variances suggest that the company should consider a change in strategy. For
example, large adverse variances caused by excessive defect rates for a new product may
suggest a flawed product design. Managers may then want to re-evaluate / re-assess the
product design and potentially change the mix of products being offered. Variances also help
managers make more informed predictions about the future thereby improving the quality of
the overall decision making process.