UNIT 1: DEFINITION & FUNCTION OF MANAGEMENT

Contents
1.0 Aims and Objectives
1.1 Introduction
1.2 Definition of Management
1.3 Levels of Management
1.4 Principles of Management
1.5 Functions of Management
1.6 Summary
1.7 Answer to Check Your Progress Exercise

1.0 AIMS AND OBJECTIVES

The aim of this unit is to introduce the student with the meaning, principle and objectives of
management.

After reading this unit you will be able to:

- know the meaning of management
- describe the principle of management, and
- identify the different functions of management.

1.1 INTRODUCTION

Management can be defined in various ways. In order to understand the term management we
can use the following definitions.

1.2 DEFINITIONS

"Management is the art of getting things done through and with people in formally organized
groups. It is the art of creating the environment in which people can perform as individuals
and yet co-operate towards attainment of group's goals.

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"Management is a process of coordinating all resources through the process of planning,
organizing, staffing, directing, leading and controlling to achieve desired objectives with the
use of human beings. (Georger Terry)

There are important terms from the above definitions of management.

 Coordination: managers in and organization should coordinate resources to achieve

objectives. Here management is a process of organizing basic resources in order to
achieve desired /stated objectives i.e.,

Basic Resource Fundamental Functions End Result

Men
Material Planning
Machine Organizing Stated Objectives
Method Staffing
Money Directing
Market Controlling

From this we can infer that management is an activity that converts disorganized human
physical resource into useful and effective results.

It is the art of removing blocks to such perform

 The other important term of the definition is objective. Every activity of manager is
directed towards goals. Objectives are the basic reasons for the establishment and/or
existence of an enterprise and it could be personal or organizational.

1.3 LEVELS OF MANAGEMENT

We can divide organizational members/people into two categories.

1. Operatives: those who work directly on job or task and have no responsibility for
overseeing the work of others.

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 2. Managers: are those people who direct the activities of other people. They are also in
a position of authority who make decision to use their skill and knowledge and the
resource of others towards the achievement of organizational objectives.

Now most firms in today's world are large and complex. These two characteristics require
managers to specialize in different functions and posses different levels of responsibilities.
These are three levels of managers/management in an organization which are discussed as
follows:

1. Top Level Management/Strategic Level of Management

They are few in numbers and includes the organizations most important managers such as
boards, general managers, president, vice president, CEO and others.

- They set company wide objectives/goals and operational policies.

- They spend much of their time in planning (strategic) and dealing with middle level
managers.
- They work long hours and spend most of their time in meeting and on telephone.
- The represent the organization in community affairs, business deals, government
negotiation etc and direct the organization in relation to the environment.

2. Middle Level Management/ Tactical Level of Management

All managers below the rank of vice president and above the level of supervisory
managers. Here the subordinates for MLM are managers. They often supervise and
coordinate the activities of lower level managers.

MLM's receive broad/overall strategies from top level managers and translate it into
specific objectives and plans for first line managers. The following are possible job titles
for middle level management. Dean, commissioner, Bishop or Superintendent Managers.

3. First Line Management/Operational Level of Management

It includes those who are at the operating or at the lowest level of management. Their
subordinates are non-management workers. Their major responsibility is to oversee and
coordinate the work of operating employees. The managerial task of FLM is to develop
the best allocation of resource that produce the desired output.

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 Vice president of a college
HLM

Dean of a college
MLM

Department heads
FLM

Operational employees

1.4 PRINCIPLES OF MANAGEMENT

Many early writers sought to define the principles of management. Chief among them was a
Frenchman named Henri Fayol, manager of a large coal company, who sought to discover
principles of management that determine the "soundness and good working order" of the firm.
Fayol was not seeking fixed rules of conduct; rather, he sought guidelines to thinking.
Deciding on the appropriateness of a principle for a particular situation was, in his view, the
art of management.

Fayol believed that any number of principles might exist, but he described only those he most
frequently applied in his own experience. Some principles of management are:

1. Division of Labor: work should be divided and subdivided into the smaller feasible
elements to take advantage of gains from specialization.
2. Party of Authority and Responsibility: each job holder should be delegated sufficient
authority to carryout assigned job responsibilities.
3. Discipline: Employees should obey whatever clearly stated agreements exist between
them and the organization: managers should fairly sanction all instances of breached
discipline.
4. Unit of Command: employees should receive order from and be accountable to only
one superior.
5. Unity of Direction: activities that have the same purpose should be grouped together
and operate under the same plan.

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 6. Subordination of individual to general interests. The interest of the organization take
precedence over the interest of the individual.
7. Fair Remuneration: pay should be based on achievement of assigned job objectives.
8. Centralization: authority should be delegated in proportion to responsibility.
9. Scalar Chain: an unbroken chain of command should exist through which all
directions and communication flow.
10. Order: each job should be defined so that the job holder clearly understand it and its
relationship to other jobs.
11. Equity: established rules and agreements should be enforced fairly.
12. Stability of Personnel: employees should be encouraged to establish loyalty to the
organization and to make a long term commitment.
13. Initiative: employees should be encouraged to exercise independent judgment within
the bounds of their delegated authority and defined jobs.
14. Espirit de Corps: employees should be encouraged to define their interests with those
of the organizations and thereby achieve unit of effort.

1.5 FUNCTIONS OF MANAGEMENT

All managers regardless of the levels in the organization or job title perform the following
five managerial functions.

1. Planning – it is the first function that all managers perform (at different degree). It is
very important because it lays down the ground work for other functions and sets the
objectives of the organization.

"If you do not have any particular destination in mind any road will get you there."

The planning function encompasses defining an organizations goal and developing a

comprehensive hierarchy of plans to integrate and coordinate activities. In short it is
deciding in advance what to do, how to do, when to do and whom to do it. In sum,
planning is an intellectual process, which focuses to the future.

2. Organizing: in order to carryout plans it is necessary to create organizations.

Organizing refers to grouping activities, assigning activities, and providing authority

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 necessary to carryout activities. Planning develops the goals and organizing creates
organizational structure to reach these goals.

3. Staffing: It refers to determining human resource needs and recruiting, selecting and
training and/or development of human resource. In general it is the process of filling the
gaps or job positions with the most qualified candidate.

4. Leading: It has been termed as motivating, directing, guiding and actuating influence
the members of the organizations towards the goals of the business. It is aimed at getting
the members of the organizations to move in the direction that will achieve its objectives.
It deals with the human factor of an organization.

5. Controlling: after the goals are set, the plans are formulated, the structural
arrangement is delineated and the peoples are hired, trained and motivated and to ensure
that all these things are going on as they should be, management must monitor the
organizations performance. This is the activity of controlling. It is the process of ensuring
that actual activities conform to planned activities.

Check Your Progress Exercise

1. Define Management.
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2. Identify the three levels of management.
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3. List and explain at least 4 principles of Henry Fayol.
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1.6 SUMMARY

Management is the process undertaken by one or more individuals to coordinate the activities
of others to achieve results not possible by one individual acting alone. The three levels of
management as top, middle and lower level have been discussed in this unit. The fourth major
principles of Fayol are also briefly examined in the unit.

1.7 ANSWER TO CHECK YOUR PROGRESS

1. Refer Section 1.2

2. Refer Section 1.3
3. Refer Section 1.4

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UNIT 2: BUDGETING

Contents
2.0 Aims and Objectives
2.1 Introduction
2.2 Meaning of Budgeting
2.3 Essentials of Budgeting
2.4 Objectives of Budgeting
2.5 Limitations of Budgeting
2.6 Summary
2.7 Answer to Check Your Progress Exercise

2.0 AIMS AND OBJECTIVES

This unit is designed to introduce students to the concepts, objectives and limitations of
budgeting.

After studying this unit, you should be able to:

- define budget
- explain the benefits and limitations of budgeting.

2.1 INTRODUCTION

Most successful companies today use operating budget to help them in their constant effort to
analyze and control operations, keep cost in line, and reduce expense, many heads of
households are familiar with the basic aspects of budgeting whereby they estimate their
income for the following year, determine what their living expenses will be, and then,
depending on the figures, reduce unnecessary spending, set up a savings plan, or possibly
determine additional ways to supplement their income. During the year, they compare their
budget with their actual income and expenditures to be sure that expenses do not exceed
income and cause financial difficulties.

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2.2 MEANING OF BUDGETING

A budget is the quantitative expression of a proposed plan of action by management for a

future time period and is an aid to the coordination and implementation of the plan. A budget
can cover both financial and non financial aspects of a plan and acts as a blue print for the
organization to follow in the upcoming period.

Budgeting in business and industry is a formal method of detailed financial planning. It

encompasses the coordination and control of every significant item in the balance sheet and
income statement. Budgeting is used to help the company reach its long-term and short-term
objectives. If the principles of budgeting are carried out in a proper manner, the company can
be assured that it will efficiently use all of its resource and achieve the most favorable results
possible in the long-run.

2.3 ESSENTIALS OF BUDGETING

The general principles of budgeting have several requirements:

1. Management must clearly define its objective.
2. Goals must be realistic and possible to attain.
3. Because the budgeting process involves looking to the future, the budget must
carefully consider economic developments, the general business climate, and the
conditions of the industry, along with changes and trends that may influence sales and
costs.
4. There must be a plan, which is consistently followed, to constantly analyze the actual
results as compared with the budget.
5. The budget must be flexible enough so that it can be modified in light of changing
conditions.
6. Responsible for forecasting costs must be clearly defined, and accountability for actual
results must be enforced.

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2.4 OBJECTIVES OF BUDGETING

Basically, the primary objective of any company is to maximize its net income or attain the
highest volume of sales at the lowest possible cost. Planning and controlling are absolutely
essential in achieving this goal, and budgeting produces the framework by which the
organization can reach this objective. The budget then becomes a road map that guides
managers along the way and let them know when the company is straying from its planned
route. In addition to forecasting costs and profits as a means of cost control, the budget
requires those in authority in all areas of business to carefully analyze all aspects of their
responsibility for costs as well as to analyze company strength and weaknesses.

Based on the above objectives of budgeting, one can identify the following benefits of
budgeting.
- Budgeting translates policy into action.
- It encourages delegation i.e., clear idea of what is expected from the members of the
business.
- It facilitates internal communication and co-ordinaiton.
- It helps to establish standard of performance. Budget is an indicator of performance.
- Forward planning focuses on operating problems early enough for action.
- Budgeting facilitates process of change within the business.
- Finally, it forces managers to become better administrators.

2.5 LIMITATIONS OF BUDGETING

As there are benefit, there are also some limitations in budgeting. The limitations are:
- A budget cannot without effective organization information system.
- Imposed budgets usually cause frustration and resentment.
- It should only include controllable items.
- Budget plans can become cumbersome/meaningless and/or inflexible when external
factors change and internal decisions get modified.
- Development of a new budge should include re-examination of standards.

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Check Your Progress Exercise
1. What is a budget?
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2. What is the benefit of using budgeting for businesses or industries?
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3. What are the six principles of good budgeting?
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4. Mention at least three limitations of a budget.
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2.6 SUMMARY

The planning process is a means of communicating objectives and co-ordinating

organizational activities in such a way as to meet those objectives. To this extent budgetary
planning is a useful device but there is a danger that budgets can constrain the organization.

Often decisions have to be made which may alter the activities identified in the plan; provided
such decision consider all of the issues involved, the budget should not be allowed to
constrain the decision maker.

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2.7 ANSWER TO CHECK YOUR PROGRESS EXERCISE

1. Refer Section 2.2

2. Refer Section 2.2
3. Refer Section 2.2
4. Refer Section 2.3

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UNIT 3: BUDGET PREPARATION FOR AN ENTERPRISE

Content
3.0 Aims and Objectives
3.1 Introduction
3.2 Participation in the Setting of Budget
3.3 Types of Budgeting
3.4 Preparing the Master Budget
3.5 Summary
3.6 Answer to Check Your Progress Exercise

3.0 AIMS AND OBJECTIVES

At the end of this unit students will have a good understanding of he basic concepts related to
the preparation of budget.

After completing this unit, you will be able to recognize the different types of budgets
prepared by business.

3.1 INTRODUCTION

The planning process is a means of communicating objectives and coordinating organizational

activities in such a way as to meet those objectives. In order to meet these objectives
effectively and efficiently the management of the organization should develop different types
of begets. One of the most commonly used budget is the master budget which is particularly
suitable for controlling costs which are unrelated to activity.

3.2 PARTICIPATION IN THE SETTING OF BUDGET

In some organizations budgets are set by higher levels of management and then
communicated to the lower levels of management to whose areas of responsibility they relate.
Thus, such budgets are seen by those lower-level managers as being imposed up on them by
their superiors in the organizational hierarchy without their being allowed to participate in the
budget-setting process and therefore without their being able directly to influence the budget

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figures. This approach to involvement in the budgetary system is consistent with Douglas
McGregor's Theory X view of how people behave in the organization. Theory X view is
based on the assumption that people in the work environment are basically lazy and dislike
work and any responsibility associated with it. They are motivated by money to meet their
basic needs. Therefore, the Theory X style of management is authoritarian, based on direction
and control down through the organization.

The other end of the spectrum is described by McGregor as Theory Y. This is a participative
theory of management, assuming that people in a work environment do seek more
responsibility and do not have to be so tightly controlled. Therefore, it is in organizations
where a Theory Y style of management predominates that one is more likely to come across a
fully participative approach to the setting of budgets.

The general argument is that the more individual managers are allowed to participate i.e., to
influence the budgets for which they are held responsible, the more likely that they will accept
the targets in the budgets and strive actively towards the attainment of those targets.

There are limitations on the extent of the effectiveness of participation in the budget setting
process. If budgets are used both in a motivational role and for the evaluation of managerial
performance then a serious conflict arise. A manager through participation may be able to
influence the budget upon which he is subsequently evaluated. By lowering the standard in
the budget he has biased the budget and he may then appear to attain a better actual
performance in any comparison with it. The effects of this sort of bias can be minimized by
careful control, and the budget setting stage, over any change in the budget from one year to
the next, which are not due to external factor.

Participation will also be less effective in organizational situations where a manager or

employee feels that he has little scope to influence the actual results for the budgeted area of
responsibility.

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3.3 TYPES OF BUDGETS

There are two types of budget. These are:

1) Fixed Budgets
It is also known as master budget and it shows income/costs for a single level of activity.

A fixed budget makes no attempt to separate the costs into those, which are fixed, and those,
which are variable. It is therefore unsuitable for use as a basis of comparison with actual costs
where such costs are known to vary with activity and the level of activity differs from that
budgeted.

However, a fixed budget is particularly suitable for controlling costs, which are unrelated to
activity. These are usually indirect costs and the aim is to limit expenditure on these items. An
example would be Research and Development expenditure.

2) Flexible Budgets
A flexible budget is a budget, which shows cost/revenues for different levels of activity by
recognizing the behavior of each cost.

The flexible budget is suitable for use as a comparison with actual costs incurred when the
activity level differ from that budgeted. Such budgets can therefore be used to measure
efficiency but are not suitable as a means of capping expenditures.

3.4 PREPARING THE MASTER BUDGET

The master or static budget is prepared for a single level of volume based on management's
best estimate of the level of production and sales for the coming period. The master budget
includes the following individual budgets.

Budgeted Income Statement Budgeted Balance sheet

- Sales budget - Cash budget
- Cost of good sold budget - Capital expenditure budget
- Production budget
- Direct material budget
- Direct labor budget

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 - Selling and administrative budget

The income statement budget for a manufacturer will be emphasized in this unit.

Figure 3.1 Income Statement Budget

Sales Budget

Production Budget

Direct Material Direct Labor Factory Overhead

Budget Budget Budget

Cost of Good
Selling & Sold Budget
Administrative
Expense Budget

Budgeted
Income
Statement

 Sales Budget
In preparing a budget, management must consider all the items of income and expense. The
usual starting point in the budgeting process is a sales forecast, followed by a determination of
inventory policy, a production plan, a budget of manufacturing costs, and a budget for all
administrative and selling expenses. The final product is the amount of net income budgeted
for the year.

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Although all of the aforementioned budgets are important, the sales budget is especially
significant, because management must use this information as a basis for preparing all other
budgets. The sales budget projects the volume of sales both in units and birr. In estimating the
sales for the forth-coming year, the sales department must take into consideration present and
future economic situations. It should research and carefully analyze market prospects for its
products and give considerations to the development of new products and the discontinuance
of old products. It should make these analysis by territory, by type of product, and possibly by
type of customer. Marketing researchers should also carefully survey and evaluate consumer
demand. After this detailed examination, the mix of the products to be sold as well as the
volume and the sales price can be determined. Figure 3-2 is the sales budget for XYZ
Company, the manufacturer of one type of table and chair.

Figure 3-2
XYZ Company
Schedule I – Sales Budget
For the Year Ended December 31, 2005
Product and Region Unit Sales Volume Unit Selling Price Total Sales
Table
West 12,000 Br 150 Br 1,800,000
South 18,000 Br 150 2,700,000
Total 30,000 Br 4, 500,000
Chair
West 40,000 Br 50 Br 2,000,000
South 60,000 Br 50 3,000,000
Total 100,000 Br 5,000,000
Total Revenue Br 9,500,000

Production Budget
After the sales mix and volume plans have been made, the factory can proceed with the
determination of production requirements. Assume the sales forecast for chair in figure 3-2,
stable production throughout the year, and an ending inventory of 2000 units greater than the

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beginning inventory. The number of chairs to be produced can be set forth in a production
budget as follows:

Units to be sold 100,000

Ending Inventory Required 4,500
Total 104,500
Beginning Inventory (2,500)
Units to be Manufactured 102,000
Units per month (102,000/12) 8500

In actual practice, this computation is more complex, management must try to achieve a
satisfactory balance between production, inventory, and the timely availability of goods to be
sold. For example, if the company's sales are seasonal rather than evenly distributed
throughout the year, stable production might result in excessive inventories of items in the
store.

Another situation is for management to schedule different levels of production each month in
order to maintain a relatively stable inventory and to minimize the number of units stored.
This condition would require hiring new employees in the periods of rising production, with
the problem of the high cost of recruiting and training as well as the problem of quality
production with new, possibly inexperienced employees. In the later periods, as production
drops many workers would be laid off, creating considerable additional expense for
unemployment compensation.

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Figure 3-3
XYZ Company
Schedule 2 – Production Budget
For the Year Ended December 31, 2005
Units
Table Chairs
Sales 30,000 100,000
Plus Desired ending inventory, Dec 31 1,500 4,500
Total 31,500 104,500
Less estimated beginning inventory, Jan 1 1,000 2,500

Total Production 30,500 102,000

 Direct Materials Budget

Once the production budget has been prepared the individual budges for manufacturing costs
can be prepared, which include the direct materials budget, the direct labor budget and the
factory overhead budget. The format of the direct materials budget is very similar to the
production budget. The desired ending inventory quantity of each material is added to the
quantity of that material needed to meet production needs, and then, the total is reduced by the
estimated quantity of beginning inventory to determine the amount of materials to be
purchased. Multiply the quantity of material to be purchased by the predetermined standard
cost per measure of that material yields the total materials purchased. The direct material
budget for XYZ Company appears in Figure 3-4.

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Figure 3-4 Direct Materials Budget
XYZ Company
Schedule 3 – Direct Materials Budget
For the Year Ended December 31, 2005
Lumber (Board feet) Paint (Gallons)
Quantities required for production
Tables (Note A) 305,000 6,100
Chairs (Note B) 510,000 10,200
Plus desired ending inventory Dec 31 40,000 800
Total 855,000 17,100
Less estimated beg. Inventory Jan 1 30,000 1000
Total quantity to be purchased 825,000 16,100
Unit Price Br 2 Br 20
Total direct materials purchases 1,650,000Br 322,000Br
Note A: 30,500 unit x 10 board feet/unit = 305,000 [Link]
30,500 unit x 0.2 gallons /unit = 6,100 gallon
Note B: 102,000 unit x 5 board feet/unit = 510,00 board feet
102,000 unit x 0.1 gallons/unit = 10,200 gallon

The standard quantity of material to be used for each unit of product is as follows:
Table Chair
Lumber: a board feet per unit 5 board feet/unit
Paint: 0.2 gallons per unit 0.1 gallons/unit

The desired beginning and ending inventories for raw materials are as follows:

Lumber Paint
(Board feet) (Gallons)
Beginning inventory 30,000 1000
Ending inventory 40,000 800

There should be close coordination between the purchasing and production functions, so that
materials are purchased as closely as possible to the time that they will be placed into

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production, thus minimizing inventory carrying costs while at the same time guarding against
stock outs.

 Direct Labor Budget

The total production requirements determined from the production budget are also needed for
the preparation of the direct labor budget. The standard labor time per unit for each factory
operation is multiplied by the number of production units to obtain the total direct labor hours
required to produce the period requirements. The total hours required for each operation are
then multiplied by the hourly rate earned by employees in each department to obtain the total
budgeted direct labor cost. The direct labor budget for XYZ Company appears in figure 3-5.

Figure 3-5 Direct Labor Budget

XYZ Company
Schedule 4 – Direct Labor Budget
For the Year Ended December 31, 2005
Cutting Assembly Painting
Hours Required for Production
Table (Note A) 7,625 6,100 4,575
Table (Note B) 10,200 15,300 10,200
Total 17,825 21,400 14,775
Hourly Rate Br 15 Br 12 Br 10
Total direct labor cost Br 267375 Br 256,800 Br 147,750
Overall direct labor cost in
the 3 departments 671,925

Note A: Cutting 30,500 units x 0.25 hours/unit = 7625 hours

Assembly 30,500 units x 0.20 hours/unit = 6,100 hours
Painting 30,500 units x 0.15 hours/unit = 4,575 hours

Note B: Cutting 102,000 units x 0.10 hours/unit = 10,200 hours

Assembly 102,000 units x 0.15 hours/unit = 15,300 hours
Painting 102,000 units x 0.10 hours/unit = 10,200 hours

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The standard quantity of labor to be used for each unit of product is as follows:

Table Chair
Cutting Department 0.25 hours/unit 0.10 hours/units
Assembly Department 0.20 hours/unit 0.15 hours/units
Painting Department 0.15 hours/unit 0.10 hours/units

Just as there was a need for close coordination between purchasing and production functions,
interaction between the human resource and production department is equally important to
ensure that there is enough of the right kind of labor available to meet production
requirements.

 Factory Overhead Budget

Here all costs incurred in the factory not chargeable directly to the finished product are called
factory overhead. These operating costs of the factory cannot be traced specifically to a unit
of production. When it is difficult to charge an expenditure to either of the "direct" factory
accounts (i.e., direct material or direct labor), it is classified as factory overhead. Generally,
factory overhead account includes (1) indirect materials consumed in the factory, such as
cleaning materials and lubricants required for production; (2) indirect factory labor; such as
wages of janitors, forklift operators and overtime premiums paid to all factory workers; and
(3) other indirect manufacturing expenses, such as rent, insurance, property taxes,
depreciation, heat light, and power.

Therefore, the factory overhead budget consists of the estimated individual factory overhead
items needed to meet production requirements. The factory overhead budget for XYZ
Company appears in figure 3-6.

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Figure 3-6 Factory Overhead Budget

XYZ Company
Schedule 5 – Factory Overhead Budget
For the Year Ended December 31,2005
Indirect materials Br. 225,000
Indirect labor 375,250
Depreciation of building 85,000
Depreciation of machinery & Equipment 67,500
Insurance and property taxes 48,750
Power and light 29,800
Total Factory overhead cost Br 831,300

 Cost of Good Sold Budget

The cost of good sold budget may be prepared upon completion of the direct materials, direct
labor, and factory overhead budgets. The estimated beginning inventories, as well as the
desired ending inventories of working process and finished goods, must be included in the
computation of cost of good sold. XYZ's projections for beginning and ending inventories are
as follows:

Estimated Beginning Inventories on Jan 1:

Finished Goods 73,500
Work in Process 22,600

Desired Ending Inventories on December 31:

Finished Goods 67,000
Work in Process 18,000

Now the cost of good sold budget for XYZ Company can be computed as follows:

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Steps in the cost of cost of good sold budget
1. Calculate the computation of material consumed as:
Beginning direct material inventory Jan. 1 Br 80,000
Plus material purchases (Schedule 3) 1,972,000
= Direct materials available for use Br 2,052,000
Less direct materials inventory, Dec. 31 (Note B) Br 96,000
Cost of Direct materials used 1,956,000

2. Compute the total cost of goods manufactured as follows:

Beginning work in process inventory (Jan. 1) 22,600
- Cost of direct materials used Br. 1,956,000
- Direct labor (Schedule 4) 671,925
- Factory overhead (Schedule 5) 831,300
3,459,225
Total work in process during the year 3,481,825
Less ending work in process 1,8000
Cost of products manufactured Br. 3,463,825

3. The final step will be the computation of costs of goods sold which can be obtained as
follows.
Beginning finished good inventory Br 73,500
Plus Cost of goods manufactured 3,463,825
Cost of goods available for sale 3,537,325
Less finished goods inventory, Dec 31 67,000
Cost of goods sold Br 3,470,325

Note A: Lumber 30,000 [Link]. x Br 2 per [Link] = Br 60,000

Paint 1 1,000 gallon x Br 20 per gallon = 20,000
Direct material inventory, Jan 1 = 80,000

Note B: Lumber 40,000 [Link]. x Br 2 per [Link] = Br 80,000

Paint 1 800 gallon x Br 20 per gallon = 16,000

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 Direct material inventory, Jan 1 = 96,000

 Selling And Administrative Expenses Budget

After a company has determined its level of activity for sales, it can prepare a selling and
administrative expense budget. The sales forecast will affect the planned expenditure level for
such items as sales force compensation, advertising, and travel. The budget has separate
section for selling and for administrative expense, with line items for each major category. A
selling and administrative expense budget appears in figure 3-8.

Figure 3-8 Selling and Administrative Budget

XYZ Company
Schedule 7 – Selling and Administrative Budget
For the year Ended December 31, 2005

Selling expenses:
Advertising expenses Br 730,300
Sales salaries expense 688,500
Travel expense 398,000
Total selling expense 1,816,800
Administrative expenses:
Officers' salaries expense Br 6,555,000
Office salaries expense 511,500
Office rent expense 65,000
Office supplies expense 32,500
Telephone expense 14,500
Total administrative expense Br 1,278,500

Total selling and administrative expense Br. 3,095,300

 Budgeted Income Statement

After completion of the preceding budgets, the company can prepare a budgeted income
statement for the year. The budgeted income statement summarizes the date from all of the

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other operating budgets and enables man agement to determine the impact of all of the budget
estimates on operating income. If the budgeted profit does not meet expectation, management
will revisit the individual budget estimates with operating personnel, for the purpose of
determining what change, if any, can be made to improve profitability. A budgeted income
statement for XYZ Company, assuming a 40% tax rate, appears in figure 3-9.

Figure 3-9 Budgeted Income Statement

XYZ Company
Budgeted Income Statement
For the Year Ended December 31,2005

Net sales (Schedule I) Br 9,500.000

Cost of good sold (Schedule 6) (3,470,325)
Gross profit Br 6,029,675
Selling & Administrative expense (Schedule 7) 3,095,300
Income from operations 2,934,375
Income tax 1,173,750
Net Income Br 1,760,625

 Other Budgets
The company can now prepare its balance sheet budgets. The cash budget shows the
anticipated flow of cash and the timing of receipts and disbursements based on projected
revenues, the production schedule, and expenses. Using this budget, management can plan for
necessary financing or for temporary investment of surplus fund.

The accounts receivable budget, based on anticipated sales, credit terms, the economy, and
other relevant factors, will influence the cash budget by showing when cash can be expected
from the turnover of inventory and receivables.

A company may also prepare a capital expenditure budget, which is a plan for the timing of
acquisitions of buildings, equipments or other significant assets during the year.

26
Check Your Progress Exercise
1. Which budget must be prepared before others? Why?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
2. If the sales forecast estimates that 50,000 units of product will be sold during the
following year, should the factory plan on manufacturing 50,000 units in the coming year?
Explain?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
3. Prepare the sales and production budget.
The sales department of X manufacturing company has forecast sales for its single product
to be 20,000 units for the month of June with three quarters of the sales expected in the
east region and one fourth expected in the west region. The budgeted selling price is Br 25
per unit. The desired ending inventory on June 30 is 3000 units and the expected
beginning inventory on June is 2000 units.

Prepare the following:

a) A sales budget for June
b) A production budget for June

4. Preparing production budget and materials budget.

The sales department of your company has forecast sales in March to be 20,000 units.
Additional information follows:

Finished goods inventory, March 1 3000 units

Finished goods inventory (required) March 31 1000 units
Material used in production
Inventory Required Standard
March 1 Inv. March 31 cost
A (one gallon/unit) 500 gallon 1000 gallon Br 2 per gall
B (one gallon/unit) 1000 lbs 1000 lbs Br 1 per lb

27
Prepare the following:
A) A production budget for March B) A material budget for the
month.

3.5 SUMMARY

The budgeting process for a manufacturing firm is much more complex than for a
merchandising or service business. Manufacturers have to budget for the acquisition of raw
materials and labor, as well as for the incurrence of a significant amount of manufacturing
overhead costs. Merchandises purchase products in their final form, and service businesses
provide a service rather than a product, thus simplifying the budgeting process. In preparing
our budget we should have to first develop the sales budget for the company, which shows
projected sales volume. Based on this sales figure we can forecast the total no of units that
should be manufactured in order to satisfy our customers and/or stock requirement. Third;
now the manufacturing of this units in the production department involves cost so we have to
prepare the material, labor and factory overhead budgets. The fourth step will be the
preparation of selling or administrative budget for the company. The final step is the
preparation of budgeted income statement, which is the summary of the above four major
steps.

3.6 ANSWER TO CHECK YOUR PROGRESS EXERCISE

1. Refer Section 3.4 3. b) Ending Inventory = 3000 units

2. Refer Section 3.4 Plus: Expected Sales = 1500
3. a) Total sales 20,000 units Less: Beg. Inv. = 2000
East = ¾ x 20,000 = 15,000 unit Production should be 16,000 units
West = ¼ x 20,000 = 5,000 units
Region Sales Price Sales
East 15,000 25 Br 15,000 x 25
West 5,000 25 Br 5,000 x 25

4. Refer 3.4

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UNIT 4: CONTROLLING

Contents
4.0 Aims and Objectives
4.1 Meaning and Definitions
4.2 Characteristics of Controlling
4.3 Importance and Nature of Controlling
4.4 Major Principles or Guides of Controlling
4.4.1 Principles Related to the Purpose & Nature of Control
4.4.2 Principles Related to the Structure of Control
4.4.3 Principles Related to the Process of Control
4.5 The Process of Control
4.5.1 Steps in the Control Process
4.6 Types of Control
4.6.1 Preliminary Control
4.6.2 Concurrent Control
4.6.3 Feedback Control
4.7 Summary
4.8 Answer to Check Your Progress Exercise

4.0 AIMS AND OBJECTIVES

After reading this unit, the student must be able to:

- define and explain what do we mean by controlling
- describe the basic characteristics of controlling
- indicate the importance and nature of controlling
- explain the major principles of controlling
- elaborate the process of control and
- describe the different types of control.

29
4.1 MEANING AND DEFINITIONS

Managerial functions commence with planning and end at controlling. The other functions
like organizing, staffing and directing are the connecting links between planning and
controlling. Controlling men at work is as old a function as the human civilization is. It is
fundamental function in every sphere if life-like the family, the academic institutions, the
trade, commerce and industry, the government and even religious places. Thus control is a
never-ending activity just as planning.

The managerial function of controlling implies, "measurement of performance against the

standard and the correction of deviations to ensure accomplishment of goals as per plan."
Thus control is the process that measures current performances and guides them forwards
some predetermined objectives. In the words of Kontz and O'Donnell, "controlling is the
measuring and correcting of activities of subordinates to ensure that events conform to plans."
According to Peter Drucker, "control maintains the equilibrium between ends and means,
output and efforts."

Controlling is a fundamental management responsibility closely linked with the planning and
organizing process. It also has an impact on motivation and team behavior. Controlling is both
a process e.g., working to keep things on schedule, and an outcome e.g., product standards.

4.3 CHARACTERISTICS OF CONTROLLING

Good controlling has the following characteristics.

- Suitability: it is appropriate to the nature, needs and circumstances of a firm and each
level of activity inside it.
- Quick reporting: since time is an important element in enforcing a control system, an
ideal control system enables any supervisor to report quickly.
- Forward planning: by forecasting the future carefully, a good control tries to prevent,
rather than remedy the situations arising from deviations.
- Pragmatic: a good control has enough flexibility so that it can be adjusted to suit the
needs of any modification or alternative in a plan.

30
 - Objective: a good control is not arbitrary and subjective. Its standards set to judge the
actual performance are clear, definite and stated in numerical terms.
- Economical: an ideal control system must not by expensive.
- Simple: a good control is easy to understand and operate.
- Internal corrective mechanism: an ideal control provides for solutions to the
problems that cause deviations.
- It is a comparison and verification process.
- It maintains a balance in activities directed towards a set of goals.
- It is a means to detect deviations from plans, policies, programs, schedules etc.

Control is made possible by two major factors. One of them is planning. Control is not
possible in the absence of planning which involves the setting of objectives to be
accomplished and the actions that need to be taken to accomplish them.

The other factor is action. Prevention is better than cure. The manager guides operations along
the desired lines. Control comes in as soon as deviations for the desired lines appear.

4.3 IMPORTANCE AND NATURE OF CONTROLLING

Controlling is an important function of management as it smoothes the working of an

organization. Without control, a manager cannot do his job. It helps in verifying whether
everything occurs in conformity with the standard set. Moreover, an effective system of
control helps in realizing the following benefits.

- Basis for future action: control helps the management to avoid repetition of past
mistakes and provides the basis for future action.
- Facilitates decision-making: control is fundamental to decision making. It helps in
determining the future course of action whenever there is a deviation between the
standard and the actual performance.
- Facilitates decentralization: the modern trend of business organizations towards
decentralization calls for a systematic attempt towards controlling. Without proper
control, decentralization cannot succeed.

31
 - Facilities Supervision: the existence of a proper control system should have a positive
impact on the behavior of the employees. It facilitates supervision.
- Improves efficiency: since a good control system smoothes away wrinkles in the
working of an organization, the morale of the employees remains high.
- Facilitates Coordination: control helps in integration of activities through unity of
action. It provides unity of direction.

Controlling is an important process used to evaluate actual performance, to compare actual

performance to goals, and then to take action on the difference between performance and
goals. Without carrying out this process, it is impossible to make sure whether plans are
implemented and desired results are achieved or not.

4.4 MAJOR PRINCIPLES OR GUIDES OF CONTROLLING

4.4.1 Principles Related to the Purpose and Nature of Control

A. Principle of the Purpose of Control: the task of control is to ensure that plans
succeed by detecting deviations from plans and furnishing a basis for taking action to
correct potential or actual undesired deviations.

B. Principle of Future Directed Control: because of time lags in the total system of
control, the more a control system is based on feed forward rather than simple feedback of
information, the more managers have the opportunity to perceive undesirable deviations
from plans before they occur and take action time to prevent them.

These two principles emphasize the purpose of control in any system of managerial action
as one of ensuring that objectives are achieved through detecting to attain them.
Moreover, control, like planning, should ideally be forward looking. This principle is
often disregarded in practice largely because the present state of art in managing has not
regularly provided for systems dependent on historical data, which may be adequate for
tax collecting and determination of stockholders earnings but are not good enough for the
most effective control. Lacking means of looking forward, reference to history, on the
questionable assumption that "the past is prologue," is better than not looking at all. But

32
 time lags in the system of management control make it imperative that greater efforts by
undertaken to make future directed control a reality.

C. Principle of Control Responsibility: the primary responsibility for the exercise of

control rests in the manager charged with the performance of the particular plans
involved. Since delegation of authority, assignment of tasks, and responsibility for certain
objectives rest in individual managers, it follows that control over this work should be
exercised by each of these managers. An individual's responsibility cannot be waived or
given up without changes in the organization structure.

- Principle of Efficiency of Controls: control techniques and approaches are efficient if

they detect and illuminate the nature and causes of deviations from plans with a
minimum of costs or other unsought consequences.

Controlling techniques have a way of becoming costly, complex, and burdensome.

Managers may become so engrossed in control that they spend more it is worth to detect
a deviation Detailed budget controls that hamstring a subordinate, complex
mathematical controls that thwart innovation and purchasing controls that delay
deliveries and cost more than the item purchased are instances of inefficient controls.

- Principle of Preventive Control: the higher the quality of managers in a managerial

system, the less will be the need for direct controls. Most controls are based in large part
on the fact that human beings make mistakes and often do not react to problems by
undertaking their correction adequately and promptly. The more qualified managers are,
the more they will effective deviations from plans and take timely action to prevent
them.

4.4.2 Principles Related to the Structure of Control

The following principles aim at pointing out how control systems and techniques can be
designed to improve the quality of managerial control.

A. Principle of Reflection of Plans: the more that plans are clear, complete, and
integrated, and the more that controls are designed to reflect such plans, the more
effectively controls will serve the needs of managers.

33
 It is not possible for a system of controls to be devised without plans since the task of
control is to ensure that plans workout as intended. There can be no doubt that the more
clear, complete, and integrated these plans are, and the more that control techniques are
designed to follow the progress of these plans, the more effective they will be.

B. Principle of Organizational Suitability: the more that an organizational structure is

clear, complete, and integrated, and the more that controls designed to reflect the place in
the organization structure where responsibility for action lies, the more they will facilitate
correction of deviation from plans. Plans are implemented by people. Deviations from
plans must be the responsibility primarily of managers who are entrusted with the task of
executing planning programs. Since it is the function of an organization structure to define
a system of roles, it follows that controls must be designed to affect the role where
responsibility for performance of a plan lies.

C. Principle of Individuality of Controls: the more that control techniques and

information are understandable to individual managers who must utilize them, the more
they will actually be used and the more they will result in effective control.

Although some control techniques and information can be utilized in the same form by
various kinds of enterprises and managers, as a general rule controls should be tailored to
meet the individual needs of managers. Some of this individuality is related to position in
the organization structure as noted in the previous principle.

Another aspect of individuality is the tailoring of control to the kind and level of
understanding of managers. We have seen both company presidents and supervisors throw
up their hands in dismay (often for quite different reasons) at the unintelligibility and
inappropriate form of control information that was a delight to the figure-and table-
minded controller. Control information which a manager cannot or will not use has little
practical value.

34
4.4.3 Principles Related to the Process of Control
Control often being so much a matter of techniques, rests heavily on the art of managing on
know how in given instances. However, there are certain propositions or principles which
experience has shown wide applicability.

A. Principle of Standards: effective control requires objective, accurate, and suitable

standards. There should be a simple, specific, and verifiable way to measure whether a
planning program is being accomplished. Control is accomplished through people. Even
the best manager cannot help being influenced by personal factors, and actual
performance is sometimes came out flagged by a dull or a sparkling personality or by a
subordinate's ability to "sell" a deficient performance. By the same token, good standards
of performance, objectively applied will more likely be accepted by subordinates as fair
and reasonable.

B. Principle of Critical Point Control: effective control requires special attention to those
factors critical to evaluating performance against plans. It would ordinarily be wasteful
and unnecessary for managers to follow every detail if plans are being implemented.
Therefore, they concentrate attention on salient factors of performance that will indicate,
without watching everything, any important deviations from plans. Perhaps all managers
can ask themselves what things in their operations will best show them whether the plans
for which they are responsible are being accomplished.

C. The Exception Principle: the more that managers concentrate control efforts on
significant exceptions, the more efficient will be the results of their control. This principle
holds that managers should concern themselves with significant deviations, the especially
good or the especially bad situations. It is often confused with the principle of critical-
point control, and they do have some kinship. However, critical-point control has to do
with recognizing the points to be watched, while the exception principle has to do with
watching the size of deviations at these points.

D. Principle of Flexibility of Controls: if controls are to remain effective, despite failure

or unforeseen changes of plans, flexibility is required in their design. According to this
principle, controls must not be so inflexibly tied in with a plan as to be useless if the entire

35
 plan fails or is suddenly changed. Note that this principle applies to failures of plans, not
failures of people operating under plans.

E. Principle of Action: control is justified only if indicated or experienced deviations

from plans are corrected through appropriate planning, organizing, staffing, and leading.

There are instances in practice where this simple truth is forgotten. Control is a wasteful use
of managerial and staff time unless it is followed by action. If deviations are found in
experienced or projected performance, action is indicated in the form of either redrawing
plans or making additional plans to get back on course. It may call for reorganization, it may
require replacement of subordinates or training them do the task desired, or there may be no
other there fault than a lack of direction and leadership in getting a subordinate to understand
the plans or to be motivated to accomplish them. But, in any case, action is implied.

4.5 THE PROCESS OF CONTROL

As a process of maintaining conformance of the system, control is defined by the following

elements (Ivancevich, 1994 pp 440-441).

A. Specification is the statement of the intended outcome. Control requires the

specification of a standard. A standard is an operationally defined measure used as a basis
for comparison. Specification fully describes the preferred condition, which may take the
form of a goal, standard or other carefully determined quantitative statement of
conditions.
B. Production means making the product or delivering the service. It is the work required
to achieve objectives, this applies equally both to service and manufacturing.
C. Inspection is a judgment concerning whether the production meets the specifications.
Inspection determines whether corrective actions need to be taken.

Clear specification of a performance standard requires an operational definition. An

operational definition converts a concept into measurable objective units. E.g., the concept
"weight" can be operationally defined in terms of grams, pounds, or another standard
measure. These measures are not subject to personal interpretation.

36
4.5.1 Steps in the Control Process
Control as a process consists of three steps:
1. Setting standards for performance of activities
A standard is a model or level of performance to be attained. It is the measure by which
performance is judged as "good" or "bad", "acceptable", or "unacceptable." Standards are
performance targets. Set standards may be either quantitative or qualitative and the control
techniques are based on these two standards.

a. Quantitative standards: are those expressed in dollars, time elapsed,

percentages, weights, distance or some other numerical terms. These standards are
reasonably price and can be measured with a relative ease. The following are some of
the most frequently used quantitative standards:
i) Time standards – indicate how much time should be
required to achieve specific results. E.g., 39 work hours per week.
ii) Cost standards – indicate how much money should
be spent to perform an activity. E.g., material or labor cost per unit.
iii) Revenue standards – indicate how much income
should be received from specific operations or activities. E.g., revenue per
sales person per month.
iv) Historical data – managers often use past results as a
basis for estimating future satisfactory performance.
v) Productivity - standards for productivity are needed
for all activities in an enterprise. Standards for measuring sales productivity
might be expressed as sales per employee per day, per week, or other time
period or sales per distribution outlet.
vi) Return on investment - (ROI) is the ratio of net
income to invested capital. E.g., if the total net income is $2 million and
the total invested capital is $10 million, the ROI is 20 percent. $ 2 million
X 100 = 20%
$10 million
vii) Profitability – while ROI indicates the ratio of net
profit to invested capital, profitability (return on sales) can be expressed as

37
 a ratio of net profit to sales. E.g., if a firm earns profits of $5 million on
sales of 50 million, the profitability ratio is 10%.
$5 million X 100 = 10%
$50 million

b. Qualitative standards are subjective and difficult to use in evaluating

performance. Qualities such as loyalty, cooperativeness, etc are examples.

2. Measuring Performance Against Standards

This involves comparing what was accomplished with what was intended to be accomplished.
A standard serves no purpose unless the degree to which it is met is determined.

In measuring performance, it is necessary to pick strategic control points for measurements.

Examples of strategic control points are given below.

i) Income – is virtually a key control point in all

organizations.
ii) Expenses over a period of time cannot exceed
income, or the organization will fall. So, key expense data are reviewed by some
managers.
iii) Inventory – its level is highly significant in many
organizations, especially those engaged in retailing, wholesaling, manufacturing and
processing. Inventory helps to determine whether production should be increased,
cut back, or kept constant. For a merchant, inventory size may indicate a need to buy
more, buy less, conduct special sales, or raise or lower prices.
iv) Product quality – the more health and safety
considerations relate to consumption of a product, the more important quality control
is.
v) Absenteeism is an important control point in
construction organizations.
vi) Safety of personnel is an important control point in
construction enterprises.

38
3. Taking Corrective Actions
This is done when performance does not meet the standards set for it. Corrective action may
involve very simple acts, such as adjusting a machine or giving employee instructions on how
to perform properly. Giving an employee instructions on how to perform properly. Correcting
a problem is often a problem. The following are some of the corrective actions.

i) Prescribed Corrective Action - is effective for

routine situations and emergencies. This action is necessary because some
problems are certain to recur while others are highly unlikely to occur again.
ii) Judgmental Corrective Action – is a subjective move
or step taken to correct shortcomings. It is clear that there are no manuals
available to provide solutions. Instead managers must rely on experience
observations of how problems in similar enterprises were solved, opinions of
other managers, and the "feel" of the situation to develop appropriate action.
While prescribed corrective action leaves little or any room for flexibility,
judgmental problem solving permits considerable latitude. There is more
challenge in using judgment than in implementing prescribed plans. But there is
also much grater risk.
iii) Engineered Measurement Devices:
Devices: Mechanical,
electronic and chemical engineering devices are available to measure machine
operations, product quality and production processes. Some of these measuring
devices have built-in mechanisms to make the necessary corrections.

- Even human behavior is subjected to measurement by engineering devices.

Department stores and libraries are detected by closed unit TV Cameras.
- Ratio Analysis examining the records of similar organization itself from
and from an earlier period E.g., Dividing current debt by inventory.
- Sampling is used to measure quality in many industries – milk processing,
concentrated orange juice production, and petroleum refining.
iv) Personal Observation:
Observation:
- Informal personal observation
- Formal personal observation

39
 - Scheduled versus surprise observation

4.6 TYPES OF CONTROL

Management has numerous control methods at its disposal. Each has strengths and
limitations. Managers must decide what type of control system to employ in different
situations. Some control techniques have very specific, limited application. Nonetheless, all
control techniques must be economical, accurate, and understandable.

Human, material, capital

and financial resources Within which planned Leading to results
acquired and combined activities occurs achieved
in organization

Preliminary Concurrent Feedback

control control control

4.6.1 Preliminary Control

It focuses on preventing deviation in the quality and quantity of resources used in the
organization. For example, human resources must meet the job requirement as defined by the
organization: Employees must have the physical and intellectual capabilities to perform
assigned tasks. Materials used in production must meet acceptable levels of quality and must
be available at the proper time and place. Capital must be on hand to ensure an adequate
supply of plant and equipment. Financial resources must be available in the right amounts and
at the right times.

Preliminary control procedures include all managerial efforts to increase the profitability that
actual results compare favorably with planned results. From this perspective, policies are
important means for implementing preliminary control since policies are guidelines for future
actions.

Management need to be concerned with preliminary control of processes in four areas:

Human resources, material, capital and financial resources.

40
Human Resources: the organizing function defines the job requirements and determines the
skill requirement of jobholders. These requirements vary in degree of specificity, depending
on the nature of the task. Preliminary control of human resources is achieved through the
selection and placement of managerial and non-managerial personnel.

Candidates for positions must be recruited from inside or outside the firm, and the most
promising applicants must be selected based on the matching skills and personal
characteristics to the job requirements. The successful candidate must be trained in methods
and procedures appropriate for the job. Most organizations have elaborate procedures for
providing training on a continual basis.

Materials: the raw materials that are converted into a finished product must conform to
quality standards before they are used in the production process. At the same time, a sufficient
inventory or delivery system must be maintained to ensure a continuous inflow of raw
materials so the manufacturer can meet customer demand.

Numerous methods that use statistical sampling to control the quality of materials have been
devised. These methods typically involve inspection of samples rather than an entire lot.
Thus, statistical methods are less costly, but there is a risk of accepting defective material if
the sample is non random or, by chance, contains none of the defective items.

Capital: the acquisition of capital reflects the need to replace existing equipment or to expand
the firm's productive capacity. Capital acquisitions are controlled by establishing criteria of
potential profitability that must be met before the proposal is authorized. Such acquisitions
ordinarily are included in the capital budget, an intermediate and long run planning document
that details the alternative sources and uses of funds. Managerial decisions that involve the
commitment of present funds in exchange for future funds are termed investment decisions.
The methods that serve to screen investment proposals are based on economic analysis.
Below are a number of widely used capital control methods. Each involves formulating a
standard that must be met to accept the prospective capital acquisition.

 The Payback Method: this is the simplest

method of capital control. The payback method calculates the number of years needed

41
 for the proposed capital acquisition to repay its original cost out of future cash
earnings.
 Rate of Return on Investment: one
alternative measure of profitability, consistent with methods ordinarily employed in
accounting is the simple rate of return on investment. The rate of return is the ratio of
additional net income to the original cost.
 Discounted Rate of Return: the discount rate
of return is a measurement of profitability that takes into account the time value of
money. It is similar to the payback method; only cash inflows and outflows are
considered. The method is widely used because it is considered the correct method for
calculating the rate of return.
 Financial Resources: adequate financial
resources must be available to ensure payment of obligations arising from current
operations. Materials must be purchased, wages paid, and interest charges and due
dates met. The principal means of controlling the availability and cost of financial
resources is budgeting particularly cash flows and working capital budgets.

These budgets anticipate the flow of business activity when materials are purchased, finished
goods are produced and inventoried, goods are sold, and cash is received. This operating cycle
results in a problem of timing the availability of cash to meet obligations. When inventories of
finished goods increase, the supply of cash decreases as materials, labor, and other expenses
are incurred and paid. As inventory is depleted through sales, cash increases. Preliminary
control of cash requires that cash be available during the period of inventory buildup and be
used wisely during periods of abundance. This requires the careful consideration of alternative
sources of short term financing during inventory build up, and alternative short run
investment opportunities during periods of inventory depletion.

4.6.2 Concurrent Control

Concurrent control monitors ongoing operations to ensure that objectives are pursued. The
standards guiding ongoing activity are derived from job descriptions and from policies
resulting from the planning function. Concurrent control is implemented primarily by the
supervisory activities of managers. Through personal, on the spot observation, managers

42
determine whether the work of others is proceeding in the manner defined by policies and
procedures. Delegation of authority provides managers with the power to use financial and
non-financial incentives to effect concurrent control.

Concurrent control consists primarily of actions of supervisors who direct the work of their
subordinates. Direction refers to the acts of managers when they:

i) instruct subordinates in proper methods and procedures and

ii) oversee subordinates' work to ensure that it's done properly.

Direction follows the formal chain of command, since the responsibility of each superior is to
interpret for subordinates the orders received from higher levels. The relative importance of
direction depends almost entirely on the nature of the tasks performed by subordinates. The
supervisor of an assembly line that produces a component part requiring relatively simple
manual operations may rarely engage in direction. On the other hand, the manager of a new
product research unit must devote considerable time to direction. Research work is inherently
more complex and varied than manual work. So it requires more interpretation and
instruction.

Directing is the primary function of the first line supervisors, but at some point every manager
in an organization engages in directing employees. The direction given should be with in the
stated organizational mission, goals and objectives. As a manager's responsibilities grow, the
relative time spent directing subordinates diminishes as other functions become more
important.

4.6.3 Feedback Control

Feedback control methods focus on end results. Corrective action is directed at improving
either the resource acquisition process or the actual operations. This type of control derives its
name from its use of results to guide future actions. The feedback control methods employed
in business organizations include budgets, standard costs, financial statements quality control,
and performance evaluation.

This section outlines two feedback control methods widely used in business:
i) Financial statement analysis and

43
 ii) Standard cost analysis

i) Financial Statement Analysis: a firm's accounting system is a principal source of

information managers can use to evaluate historical results. Periodically, the manager
receives a set of financial statements that usually includes a balance sheet and income
statement. These financial statements summarize and classify the effects of transactions
in assets, liabilities, equity, revenues and expenses – the principal contents of the firm's
financial structure. The balance sheet describes an organization's financial condition at a
specified point in time. The income statement is a summary of an organization's
financial performance over a given time period.

A detail analysis of the financial statement's information enables management to

determine the adequacy of the firm's earning power and its ability to meet current and
long term obligations. Managers must have measures of and standards for profitability,
liquidity and solvency. Whether a manager prefers the rate of return on sales, on owner's
equity, on total assets, or a combination of all three, it's important to establish a
meaningful norm – one that is appropriate to the particular firm, given its industry and
stage of growth. An inadequate rate of return negatively affects the firm's ability to
attract funds for expansion, particular if downward trend overtime is evident.

The measures of liquidity reflect the firm's ability to meet current obligations as they
become due. The widest known and most often used measure is the current ratio (the
ratio of current assets to current liabilities). The standard of acceptability depends on the
particular firm's operating characteristics. Bases for comparison are available from trade
associations that publish industry averages. A tougher test of liquidity is the acid test
ratio,
ratio, which relates only cash near cash items (current assets excluding inventories and
prepaid expenses) to current liabilities.

The relationship between current assets and current liabilities is an important one.
Equally important is the composition of current assets. Two measures that indicate
composition and rely on information found in both the balance sheet and income
statement are the accounts receivable turnover and the inventory turnover. The accounts
receivable turnover is the ratio of credit states to average accounts receivable. The

44
 higher the turnover, the more rapid the conversion of accounts receivable to cash. A low
turnover would indicate a time lag in the collection of receivables, which in turn could
strain the firm's ability to meet its own obligations. Appropriate corrective action might
be tightening of credit standards or a more vigorous effort to collect outstanding
accounts. The inventory turnover also facilitates the analysis of appropriate balances in
current assets. It is calculated as the ratio of cost of goods sold to average inventory. A
high ratio could indicate a dangerously low inventory balance in relation to sales, with
the possibility of missed sales or a production slowdown. Conversely, a low ratio might
indicate an over investment in inventory to the exclusion of other, more profitable
assets. Whatever the case, the appropriate ratio must be established by the manager,
based on the firm's experience within its industry and market.

Another financial measure is solvency,

solvency, the ability of the firm to meet its long-term
obligations – its fixed commitments. The solvency measure reflects the claims of
creditors and owners on the firm's assets. An appropriate balance must be maintained – a
balance that protects the interest of the owner yet doesn't ignore the advantages of long
term debt as a source of funds. A commonly used measure of solvency is the ratio of net
income before interest and taxes to interest expense. This indicates the margin of safety;
ordinarily, a high ratio is preferred. However, a very high ratio combined with a low
debt-to-equity ratio could indicate that management has not taken advantage of debt as a
source of funds. The appropriate balance between debt and equity depends on many
factors. But as a general rule, the portion of debt should vary directly with the stability
of the firm's earnings.

Firms also use debt ratios to assess the amount of financing being provided by creditors.
Two popular debt ratios are the debt/equity ratio and the debt/asset ratio. The
debt/equity ratio is a measure of the amount of assets financed by debt compared to that
amount financed by profits retained by the firm and investments (stocks and other
securities). The debt/asset ratio is an expression of the relationship of the firms total
debts to its total assets.

ii) Standard Cost Analysis: standard cost accounting systems are considered a major
contribution of the scientific management era. A standard cost system provides

45
 information that enables management to compare actual costs with predetermined
(standard) costs. Management can then take appropriate corrective action or assign to
others the authority to take action. The first use of standard costing was to control
manufacturing costs. In recent years, standard costing has also been applied to selling,
general and administrative expenses. Here we discuss standard manufacturing costs.

The three elements of manufacturing costs are direct labor, direct materials and
overhead. For each of these, an estimate must be made of cost per unit of output. For
example, the direct labor cost per unit of output consists of the standard usage of labor
and the standard price of labor. The standard usage derives from time studies that fix the
expected output per labor hour; the standard price of labor is fixed by the salary
schedule appropriate for the kind of work necessary to produce the output. A similar
determination is made for direct materials.

The accounting system enables the manager to compare incurred costs and standard
costs. Today, cost accounting practices are undergoing significant changes to keep pace
with the rapidly evolving manufacturing environment. Activity based accounting, a new
system of cost accounting based on activity, has been advocated by many academicians
and practitioners. Its underlying principle is that activities consume resources and
products consume activities. The labor costs of supporting departments can be traced to
activities by assessing the portion of each person's time spent on each activity, which
can then allow for restatement of departmental cost in activities and their associated
costs. Activity costs then are traced to the product based on the amount of activity
volume each product consumes. The overall impact is more accurate product costs
information.

Check Your Progress Exercise

1. What is controlling? Explain in brief.
…………………………………………………………………………………………………
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2. Describe some of the basic characteristics of controlling.

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…………………………………………………………………………………………………
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3. How do you define the benefits of controlling?
…………………………………………………………………………………………………
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4. Explain the steps in the control process.
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5. Discuss the three basic types of controlling.
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4.7 SUMMARY

Like many management terms, control has different meanings to different people so an
individual's concept of control often reflects a personal perspective. Statisticians may think of
control in terms of specifications, monitoring and feedback, and managers think of controlling
the activities, attitudes and performance of subordinates. Despite these differing approaches to
control, there are some characteristics of all organizations that must be controlled: productions
and operations, financial resources, human resources and organizational change and
development.

After planning or making decision, managers must deploy organizational resources to achieve
specific goals or objectives. Even though decision making and planning are conducted
systematically and with accurate information, unexpected circumstances may yet arise.
Unforeseen events may occur in the social, economic, political or natural environment. Thus,
managers must be prepared to redirect organizational activities toward desired ends. To do
this they need an understanding of the elements of control.

In the three types of control we just examined, the focus of corrective action differs.
Preliminary control methods are based on information that measures some attributes or
characteristics of resources; corrective action focuses on resources. Concurrent control

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methods are based on information related to ongoing process; corrective action is focused on
these processes. The focus of corrective action associated with feedback control is not that
which is measured i.e., results. Rather, feedback control provides information concerning the
quality and/or effectiveness of resources and processes.

4.8 ANSWER TO CHECK YOUR PROGRESS EXERCISE

1. Managerial function implies "measurement of performance against the standard and

the correction of deviations to ensure accomplishment of goals as per plan."
2. Basic characteristics of controlling:
- sub stability - pragmatic
- quick reporting - objective
- forward planning - economical
- sample
- internal corrective mechanism and for more information refer to Section 4.2
3. Controlling helps in realizing the following benefits:
- basis for future action
- facilitates decision making
- facilitates decentralization
- facilitates supervision
- improves efficiency
- facilitates coordination and for the details refer to Section 4.3
4. Control as a process consists of three steps.
a) Setting standards for performance of activities
b) Measuring performance against standards
c) Taking corrective actions. For more details look at Section 4.5.1
5. The three basic types of controlling includes:
a) Preliminary control
b) Concurrent control
c) Feedback control. For more on this refer to Section 4.6

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UNIT 5: MANAGEMENT CONTROL SYSTEM

Contents
5.0 Aims and Objectives
5.1 Introduction
5.2 Core Management Control System
5.3 Top Management Financial Control
5.3.1 Financial Statements: The Basic Numbers
5.3.2 Financial Analysis: Interpreting the Numbers
5.3.3 Financial Audits: Verifying the Numbers
5.4 Middle Management Budget Control
5.4.1 Responsibility Centers
5.4.2 Operating Budgets
5.4.3 Financial Budgets
5.5 The Budgeting Process
5.5.1 Top Down or Bottom-up Budgeting
5.5.2 Zero-Based Budgeting
5.6 Trends in Financial Control
5.6.1 Open-Book Management
5.6.2 Economic Value-added Systems
5.6.3 Activity Based Costing (ABC)
5.7 Signs of Inadequate Budget Control Systems
5.8 Summary
5.9 Answer to Check Your Progress Exercise

5.0 AIMS AND OBJECTIVES

After reading this unit, the student must be able to:

- understand and define the core management control system
- explain the basic top management and middle management financial and budget
control
- describe the basic budgeting processes

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 - elaborate the trends in financial control and,
- indicate signs of inadequate budget control systems.

5.1 INTRODUCTION

Every organization needs basic systems for allocating financial resources, approving and
developing human resources, analyzing financial performance, and evaluating operational
productivity. In long established organizations the challenge for managers is to know how to
use these control systems and improve them. In new, entrepreneurial firms – specially those
that have grown rapidly – managers must design and implement new control systems.

We will begin by explaining how multiple control systems fit together to provide overall
control for top managers and then examine control systems used by middle managers.

5.2 CORE MANAGEMENT CONTROL SYSTEM

Research into the design of control systems across organizations has revealed the existence of
a core management control system. The core control system consists of strategic plans,
financial forecasts, budgets, management by objectives, operations management techniques
and MIS reports that together provide an integrated system for directing and monitoring
organizational activities. The elements of the core control system and their relationship to one
another are indicated in the figure below.

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 Strategic Plan

Financial Forecast

Management by objectives Operations management

performance appraisal system
systems

Operating Budget Manufacturing or Management information

service operations system (MIS)

Targets, Standards
Information on performance Fig. 6.1 Core control system components

The strategic plan consists of the organization's strategic goals and is based on in-depth
analysis of the organization's industry position, internal strengths and weaknesses, and
environmental opportunities and threats. The financial forecast is based on a one-to five-year
project of company sales and revenues and is used to project income statements, balance
sheet, and departmental expenditures. The operating budget is an annual projection of
estimated expenses, revenues assets and related financial figures for each operating
department for the coming year. Budget reports typically are issued monthly and include
comparisons of expenditures with budget targets. Budget reports are developed for all
divisions and departments.

Many companies also use management by objectives to direct employee activities toward
corporate goals. MBO is integrated into the performance appraisal system and enhances

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management control. Operations management systems and reports pertain to inventory
(economic order quantity, just in time), purchasing and distribution systems, and project
management (PERT charts). Management Information Systems (MIS) reports are composed
of statistical data, such as personnel complements, volume of orders received, delinquent
account ratios, percentage sales returns, and other statistical data relevant to the performance
of a department or division.

Each control system component is separate and distinct from the others. However, a
successful core control system combines them into an integrated package of controls. In
recent years, many companies have adopted new approaches to simultaneously control costs
and improve organizational performance. The manager's shoptalk box describes how
technology driven, "paperless" management systems are helping companies meet new needs.

5.3 TOP MANAGEMENT FINANCIAL CONTROL

Based on the overall strategic plan, top management must define a financial forecast for the
organization, perform financial analysis of selected ratios to reveal business performance, and
use financial audits to evaluate internal operations. Each of these controls is based on
financial statements – the building blocks of financial control.

5.3.1 Financial Statements: The Basic Numbers

Financial statements provide the basic information used for financial control of a company.
Two major financial statements – the balance sheet and the income statement – are the
starting points for financial control.

The balance sheet shows the firm's financial position with respect to assets and liabilities at a
specific point in time. An example of a balance sheet is presented in the table below. The
balance sheet provides three types of information; assets, liabilities and owner's equity. Assets
are what the company owns and include current assets (assets that can be converted into cash
in a short time period) and fixed assets (assets such as buildings and equipment that are long
term in nature). Liabilities are the firm's debts and include both current debt (obligations that
will be paid by the company in the near future) and long-term debt (obligations payable over a

53
long period). Owner's equity is the difference between assets and liabilities and is the
company's net worth in stock and retained earnings.

NUGET BROTHERS
Consolidated Balance Sheet
December 31, 19x1
Assets Liabilities & Owner's Equity
Current Assets Current Liabilities:
Cash $ 25,000 Accounts Payable $ 200,000
Accounts receivable 75,000 Accrued Expenses 20,000
Inventory 500,000 Income Tax Payable 30,000
Total Current Assets 600,000 Total Current Liabilities 250,000
Fixed Assets Long Term Liabilities
Land 250,000 Mortgages Payable 350,000
Building 1,000,000 Bonds Outstanding 250,000
Less Depreciation (200,000) Total 600,000
Total Fixed Assets 1,050,000 Owners Equity
Common Stock 540,000
Retained Earnings 260,000
Total 800,000
Total Assets $ 1,650,000 Total Liabilities & Net Worth $ 1,650,000

The income statement, sometimes called a profit-and-loss statement, summarizes the firm's
financial performance for a given time interval usually one year. A sample income statement
is given in the table below. Some firms calculate the income statement at three-months
intervals during the year to see if they are on target for sales and profits. The income
statement shows revenues coming into the organization from all sources and subtract all
expenses, including cost of goods sold, interest, taxes, and depreciation. The bottom line
indicates the net income – profit or loss – for the given time period.

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 NUGET BROTHERS
Statement of Income
For the Year Ended December 31, 19x1
Gross Sales $ 3,100,000
Less Sales Returns 200,000
Net Sales $ 2,900,000
Less Expenses and Cost of Goods Sold:
Cost of Goods Sold 2,110,000
Depreciation 60,000
Sales Expenses 200,000
Administrative Expenses 90,000 2,460,000
Operating Profit 440,000
Other Income 20,000
Gross Income 460,000
Less Interest Expense 80,000
Income Before Taxes 380,000
Less Taxes 165,000
Net Income $215,000

For example, some organizations used the income statement to detect that sales and profits
were dropping during certain periods. And they immediately evaluate company activities and
take action on some losing stores. This use of the income statement follow the control cycle,
beginning with the measurement of actual performance and then taking corrective action to
improve performance to meet targets.

5.3.2 Financial Analysis: Interpreting the Numbers

The most important numbers typically are not actually dollars spent or earned but ratios. Any
business is a set of hundreds of relationship among people, things, and events. Key
relationships are typically revenue in ratios that provide insight into some aspect of company
behavior. These insights make manager decision making possible. A financial ratio is the
comparison of two financial numbers. To understand their business, managers have to
understand financial ratios.

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Several financial ratios can be studied to interpret company performance. Managers must
decide which ratios reveal the most important relationships for their business. Frequently
calculated ratios typically pertain to liquidity, activity, and profitability. Many companies
compare their performance with those of other firms in the same industry as well as with their
own budget targets.

Liquidity Ratio: it indicates the organization's ability to meet its current debt obligations. For
example, the current ratio tells whether there are sufficient assets to convert into cash to pay
off debts if needed. If a hypothetical company had current asset of $600,000 and current
liabilities of $ 250,000, the current ratio is 2.4, meaning it has sufficient funds to pay off
immediate debts 2.4 times. This is normally considered a satisfactory margin of safety.

Activity Ratio: it measures internal performance with respect to key activities defined by
management. For example, inventory turnover is calculated by dividing total sales by average
inventory. This ratio tells how many times the inventory is turned over to meet the total sales
figure. If inventory sits too long, money is wasted.

Profitability Ratio: it describes the organization's profits. One important profitability ratio is
the profit margin on sales, which is calculated as net income divided by sales. Another
profitability measure is return on total assets (ROA), which is the percentage return on
investors on assets. It is a valuable yardstick of the return on investment compared with their
investment opportunities.

Analyzing these various financial ratios can help managers of different companies understand
their business more clearly, especially with the increase in global competition.

5.3.3 Financial Audits: Verifying the Numbers

Financial audits are independent appraisals of the organizations financial records. Audits are
of two types – External and Internal.
Internal. An external audit is conducted by experts, from outside
the organization, typically certified public accountants (CPAs) or CPA firms. An internal
audit is handled by experts within the organization. Large companies have an accounting staff
assigned to the internal audit function. The internal auditors evaluate departments and
divisions throughout the corporation to ensure that operations are efficient and conducted
according to prescribed company practices.

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Both external and internal audits should be thorough. Their purpose is to examine every nook
and cranny to verify that the financial statement represents actual company operations. The
following are some of the areas examined by auditors:
- Cash: go to banks and confirm bank balance, review cash management procedures.
- Receivables: obtain guarantees from customers concerning amounts owed and
anticipated payments; confirm balances.
- Inventory: conduct physical count of inventory and compare with financial statement;
review for obsolescence.
- Fixed assets: make physical observation, evaluate depreciation determine whether
insurance is adequate.
- Loans: review loan agreements; summarize obligations.
- Revenues and expenses: evaluating timing, propriety and amount.

Using Financial Controls

Remember that the point of financial numbers is to gain insight into company relationships to
identify areas out of control and take corrective action. Managers must use numbers wisely
and see beneath the surface to decide exactly what is causing the problem and devise a
solution. A financial performance short fall often has several causes, and managers must be
familiar with company operations and activities in order to make an accurate diagnosis.
Managers can use numbers creatively and dig beneath the figures to find the causes of
problems. After defining the causes, they can initiate programs that will rectify the problem
and bring the financial figures back into line.

5.4 MIDDLE MANAGEMENT BUDGE CONTROL

Budgets are a primary control device for middle management. Of course, top managers too
are involved with budgets for the company as a whole, but middle managers are responsible
for the budget performance of their departments or divisions. Budgets identify both planned
and actual expenditures for cash, assets, raw materials, salaries, and other resource
departments need. Budgets are the most widely used control system, because they plan and
control resources and revenues essential to the firm's health and survival.

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A budget is created for every division or department with in the organization, no matter how
small, so long as it performs a distinct project, program or function. In order for budgets to be
used, the organization must define each department as a responsibility center.

5.4.1 Responsibility Centers

A responsibility center is the fundamental unit of analysis of budget control system. A
responsibility center is defined as any organizational department under the supervision of a
single person who is responsible for its activity. There are four major types of responsibility
centers – cost centers, revenue centers, profit centers, and investment centers.

Cost Center: a cost center is a responsibility center in which the manager is held responsible
for controlling cost inputs. The manager is responsible for salaries, supplies and other costs
relevant to the department's operation. Staff departments such as human resource, legal and
research typically are organized as cost centers and budgets reflect the cost to run the
department.

Revenue Center: a revenue center, the budget is based on generated revenue or income.
Sales and marketing departments frequently are revenue centers. The department has a
revenue goal, such as $3,500,000. Assuming that each sales person can generate $250,000 of
revenue per year the department can be allocated 14 sales people. Revenue budgets can also
be calculated as the number of items to be sold rather than as total revenues.

Profit Center: in a profit center, the budget measures the difference between revenues and
costs. For budget purposes, the profit center is defined as a self-contained unit to enable a
profit to be calculated. Control is based on profit targets rather than on cost or revenue targets.

Investment Center: an investment center is based on the value of assets employed to

produce a given level of profit. Profits are calculated in the same way as in a profit center, but
for control purposes, managers are concerned with return on the investment in assets for the
division. For example, XYZ Co. may acquire a garment factory for a price of $40 million. If
XYZ managers target a 10 percent return on investment, the garment factory will be expected
to generate profits of $4 million a year. XYZ managers are not concerned with the absolute

58
dollar value of costs, revenues or profits so long as the budgeted return on assets reaches 10
percent.

Relationship to Structure: responsibility centers are closely related to the types of

organizations structure. Cost centers and revenue centers typically exist in a functional
structure. The production, assembly, finance, accounting and human resource departments
control expenditures through cost budgets. Marketing or sales departments, however, often
are controlled as revenue centers. Profit centers typically exist in a divisional structure. Each
self-contained division can be evaluated on the basis of total revenues minus total costs,
which equals profits. Finally, very large companies in which each division is an autonomous
business use investment centers.

5.4.2 Operating Budgets

An operating budget is the financial plan for each organizational responsibility center for the
budget period. The operating budget outlines the financial resources allocated to each
responsibility center in dollar terms, typically calculated for a year in advance. The most
common types of operating budgets are expense, revenue and profit budgets.

Expense Budgets: an expense budget outlines the anticipated expenses for each responsibility
center and for the total organization. Expense budgets apply to cost centers, as described
previously. The department of management at the Unity University College may have a travel
budget of $ 24,000; thus, the department head knows that the expense budget can be spent at
approximately $ 2000 per month. Three different kinds of expenses normally are evaluated in
the expense budget – fixed, variable and discretionary.

Fixed Costs: are based on a commitment from a prior budget period and cannot be changed.
The price of expensive machinery purchased 3 years ago that is paid over a period of 10 years
is a fixed cost.

Variable Costs: often called engineered costs, are based on an explicit physical relationship
with the volume of departmental activity. Variable costs are calculated in manufacturing
departments when a separate cost can be assigned for each product produced. The greater the
volume of production, the greater the expense budget the department will have.

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Discretionary Costs: are based on management decisions. They are not based on a fixed,
long term commitment or on the volume of items produced, because discretionary costs
cannot be calculated with precision. In the judgment of top management, an expense budget
of $ 120,000 might be assigned to the inspection department to pay the salaries of four
inspectors, one assistant and one secretary. This budget could be increased or decreased the
following year, depending on whether management feels more inspectors are needed.

Revenue Budget: a revenue budget identifies the revenues required by the organization. The
revenue budget is the responsibility of a revenue center, such as marketing or sales. The
revenue budget for a small manufacturing firm could be $ 3 million, based on sales of
600,000 items at $ 5 each. The revenue budget of $ 6 million for a local school district would
be calculated not on sales to customers but on the community's current tax rate and property
values.

Profit Budget: a profit budget combines both expense and revenue budgets into one
statement to show gross and net profits. Profit budgets apply to profit and investment centers.
If a bank has budgeted income of $ 2 million and budgeted expenses of $ 1,800,000, the
estimated profit will be $ 200,000. If the budget profit is unacceptable, managers must
develop a plan for increasing revenues or decreasing costs to achieve an acceptable profit
return.

5.4.3 Financial Budgets

Financial budgets define where the organization will receive its cash and how it intends to
spend it. Three important financial budgets are the cash, capital expenditure, and balance
sheet budgets.

Cash Budget: the cash budget estimates cash flows on a daily or weekly basis to ensure that
the organization has sufficient cash to meet its obligations. The cash budget shows the level of
funds flowing through the organization and the nature of cash to meet its obligations. The
cash budget shows the level of funds flowing through the organization and the nature of cash
disbursements. If the cash budget shows that the firm has more cash than necessary, the
company can arrange to invest the excess cash in treasury bills to earn interest income. If the

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cash budget shows a payroll expenditure of $20,000 coming at the end of the week but only
$10,000 in the bank, the controller must borrow cash to meet the payroll.

Capital Expenditure Budget: the capital expenditure budget plans future investments in
major assets such as buildings, trucks and heavy machinery. Capital expenditures are major
purchases that will be depreciated over several years. Capital expenditures must be budgeted
to determine their impact on cash flow and whether revenues are sufficient to cover capital
expenditures and cash management, revenues and operating expenses will mesh into the
financial results desired by senior management. The balance sheet budget shows where future
financial problems may exist. Financial ratio analysis can be performed on the balance sheet
and profit budgets to see whether important ratio targets, such as debt total assets or ROA will
be met.

5.5 THE BUDGETING PROCESS

The budgeting process is an integral part of the planning process and is concerned with how
budgets are actually formulated and implemented in an organization. Budgets are allocated
during the strategic planning process commensurate with agreed-upon goals. In this section,
we will briefly describe the procedure many companies use to develop the budget for the
coming year.

5.5.1 Top Down or Bottom-Up Budgeting

Many traditional companies use top-down budgeting, which is consistent with the
bureaucratic control approach. The budgeted amounts for the coming year are literally
imposed on middle and lower-level managers. The top down process has certain advantages:
Top managers have information on overall economic projections; they know the financial
goals and forecasts; and they have reliable information about the amount of resources
available in the coming year. Thus, the top-down process enables managers to set budget
targets for each department to meet the needs of overall company revenues and expenditures.

The problem with the top-down budgeting process is that lower managers often are not
committed to achieving budget targets. They are excluded from the budgeting process and

61
resent their lack of involvement in deciding the resources available to their departments in the
coming year.

In response to these negative outcomes, many organizations adopt bottom-up budgeting,

which is in line with the decentralized approach to control. Lower managers anticipate their
departments' resource needs, which are passed up the hierarchy and approved by top
management. The advantage of the bottom-up process is that lower managers are able to
identify resource requirements about which top managers are uninformed, have information
on efficiencies and opportunities in their specialized areas, and are motivated to meet the
budget because the budget plan is their responsibility.

However the bottom up approach also has problems. Because managers are evaluated on their
performance against the budget, they may not be motivated to make their budget submissions
very challenging, striving instead for the most conservative budget that can get approval.
Another problem is that managers' estimates of future expenditures may be inconsistent with
realistic economic projections for the industry or with company financial forecasts and goals.

The result of these advantages and disadvantages is that many companies use a joint process.
Top managers are the controller define economic projections and financial goals and forecasts
and then inform lower managers of the anticipated resources available to them. Once these
overall targets are made available, department managers can develop their budgets within
them. Each department can take advantage of special information, resource requirements, and
opportunities. The budget is then passed up to the next management level, where
inconsistencies across departments can be removed.

The combined top-down and bottom up process is illustrated in the figure below. Top
managers begin the cycle. They also end it by giving final approval to all departmental
budgets. Departmental budgets fall with in the guidelines approved by top management, and
the overall company budget reflects the specific knowledge, needs and opportunities with in
each departments.

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 President

Controller

Fig 6.2

Top-Down and Bottom-Up Budgeting

Top-Down Bottom-Up
 Provides overall economic  Identifies specific resources
projections requirements.
 Conveys corporate financial goals  Includes economies and
and forecast opportunities in specialized areas.
 Tells resource availability and range  Resolves resource inconsistencies
of budget amounts among departments.
 Increases employee commitment.

5.5.2 Zero-Based Budgeting

In most organizations, the budgeting process begins with the previous year's expenditures;
that is, managers plan future expenditures as an increase or decrease over the previous year.
This procedure tends to lock departments into a stable spending pattern that lacks flexibility to
meet environmental changes. Zero base budgeting was designed to overcome this rigidity by
having each department start from zero in calculating resource needs for the new budget
period. Zero base budgeting assumes that the previous year's budget is not a valid base from

63
which to work. Rather, based on next year's strategic plans, each responsibility center justifies
its work activities and needed personnel, supplies, and facilities for the next budget period.
Responsibility centers that cannot justify expenditures for the coming year will receive fewer
resources or be disbanded altogether. In zero base budgeting, each year is viewed as bringing
a new set of goals. In forces department managers to thoroughly examine their operations and
justify their departments' activities based on their direct contribution to the achievement of
organizational goals.

The zero-base budgeting technique was originally developed for use in government
organizations as a way to justify cost requests for the succeeding year. The specific steps used
in zero-based budgeting are as follows:

1. Managers develop a decision package for their responsibility centers. The decision
package includes written statements of the department's goals, activities, costs and
benefits; alternative ways of achieving goals, consequences of not performing each
activity and personnel, equipment, and resources required during the coming year.
Managers then assign a rank order to the activities in their department for the coming
year.
2. The decision package is then forwarded to top management for review. Senior
managers rank the decision packages from the responsibility centers according to
their degree of benefit to the organization. These rankings involve widespread
management discussions and may culminate in a voting process in which managers
rate activities from "essential" to "would be nice to have" to "not needed".
3. Top management allocates organizational resources based on activity rankings.
Budge resources are distributed according to the activities rated as essential to
meeting organizational goals. Some departments may receive large budgets and
others nothing at all.

Zero-based budgeting demands more time and energy than conventional budgeting. Because
it forces management to abandon traditional budget practices, top management should
develop a consensus among participants that zero-based budgeting will have a positive
influence on both the company and its employees.

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5.6 TRENDS IN FINANCIAL CONTROL

Today companies are responding to changing economic realities and global competition by
reassessing organizational management and processes – including the way they control their
finances. Some of the major trends in financial control include open-book management,
economic value added systems and activity based costing.

These trends have emerged from changing organizational structures and the resulting
management methods that stress information sharing, employee participation, and teamwork.
The realities of higher quality demands from consumers, together with the need to cut costs
while improving product and service, also require new approaches to financial control.

5.6.1 Open-Book Management

In the changing organizational environment that touts information sharing, teamwork and
managers as facilitators rather than bosses, top executives do not hoard financial data.
Employees throughout the organization are admitted into the loop of financial control and
responsibility to encourage active participation and commitment to organizational goals.

Open book management provides employees with the "why" to reorganization, cost cutting,
customer service and other organizational strategies.

- First, open book management allows employees to see for themselves – through
charts, computer printouts, meetings and so forth – the financial condition of the
company.
- Second, open book management shows the individual employee how his or her job fits
into the picture and affects the financial future of the organization.
- Finally, open book management ties employee rewards to the company's overall
success. As employee see the interdependence and importance of each function, cross
functional communication and cooperation are enhanced.

The goal of open book management is to get every employee thinking and acting like a
business owner rather than like a hired hand. To get employees to think like owners, they are
provided with the same information as owners and given responsibility and authority to act on

65
what they know. Top management support and regular communication with employees
throughout the company are essential to the success of open-book management.

5.6.2 Economic Value-added System

Economic value added system can be defined as a company net operating profit after taxes
and after deducting the cost of capital. Economic value added measurement captures all the
things a company can be to add value from its activities, such as run the business more
efficiently, satisfy customers, and reward shareholders. Each job department or process in the
organization is measured by the value added.

To be successful, economic value added be central to the financial management system and
integrated throughout company policies and procedures. In addition, employees throughout
the organization should be trained, because even the smallest jobs can help create value for
the company. When implemented properly, economic value added systems can effectively
measure and help control a company's financial performance.

5.6.3 Activity Based Costing (ABC)

In recent years, the dramatic rise in production concepts such as just-in-time manufacturing
and total quality management (TQM) created a financial dilemma for corporate accountants.
Often a product would cost for more to manufacture that it could be sold for, but costing
systems hid this fact, losing the company a lot of money.

The relationship between labor and overhead has changed. Increased automation has resulted
in less employee labor. Total product costs are driven to a degree by higher overhead costs for
setup, distribution, and maintenance of sophisticated machinery. In addition, small-batch
production to meet changing consumers desires drivers up costs.

Activity based costing assumes that true costs are reflected by a formula under which
products consume activities and activities consume resources. The crucial step is identifying
various activities needed to produce a product and determining the costs of those activities.
Costs are then allocated to products accordingly. For example, a manufacturing division may
develop three cost pools:

66
 1. Procurement overhead: including incoming documentation, storage, inspection and
logistics.
2. Production overhead: including various steps in the production process, such as start-
up- stations, soldering and testing and defect analysis.
3. Support overhead: including production and process engineering and data processing.

For each pool, overhead costs are measured and allocated according to the true cost of
specific products.

The activity based costing process can provide an accurate reflection of product costs by
measuring specific cost factors. The key is the selection of appropriate activities and selection
of an allocation base that best reflects each activity. Activity-based costing is appealing
because implementation does not interfere with the financial accounting system, and it can be
tailored to specific company needs.

5.7 SIGNS OF INADEQUATE BUDGET CONTROL SYSTEMS

Financial statements, financial analysis, and budgets are designed to provide adequate control
for the organization. Often, however, management control systems are not working properly.
Then they must be examined for possible clarification, revision or overhaul. Indicators of the
need for a more effective control approach or revised management control systems are as
follows:
- deadlines missed frequently
- poor quality of goods and services
- declining or stagnant sales or profits
- loss of leadership position or market share within the industry.
- Inability to obtain data necessary to evaluate employee or departmental performance
- Low employee morale and high absenteeism
- Insufficient employee involvement and management employee communications
- Excessive company debts, uncertain cash flow, or unpredictable borrowing
requirements
- Inefficient use of human and material resources, equipment and facilities.

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Management control systems help achieve overall company goals. They help ensure that
operations progress satisfactorily by identifying deviations and correcting problems. Properly
used, controls help management respond to unforeseen developments and achieve strategic
plans. Improperly designed and used, management control systems can lead a company into
bankruptcy.

Check Your Progress Exercise

1. What is the core control system? How do its components relate to one another for
control of the organization?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
2. What are the four types of responsibility centers, and how do they relate to
organization structure?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
3. Explain the difference among fixed costs, variable costs, and discretionary costs. In
which situation would each be used?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
4. What are the advantages of top-down versus bottom-up budgeting? Why is it better to
combine the two approaches?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

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5. Why might low employee morale or insufficient employee involvement be indicators
of inadequate controls in an organization?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

5.8 SUMMARY

This unit introduces a number of important concepts about management control systems and
techniques. Organizations have a core management control system consisting of the strategic
plan, financial forecast, operating budget, management by objectives, operations management
system and management information system. Top management financial control uses the
balance sheet, income statement, and financial analysis of these documents.

At the middle levels of the organization, budgets are an important control system.
Departments are responsibility centers, each with a specific type of operating budget –
expense, revenue or profit. Financial budgets are also used for organizational control and
include the cash, capital expenditure, and the balance sheet budget. The budget process can be
either top down or bottom up, but a budget system that incorporates both seems most effective
– zero-based budgeting is a variation of the budget process and requires that managers start
from zero to justify budget needs for the coming year. Recent trends in financial control
include open-book management, economic value-added measurement systems, and activity
based costing. Finally, indicators of inadequate budget control systems were discussed.

5.9 ANSWER TO CHECK YOUR PROGRESS EXERCISE

1. Core control system consists of strategic plans, financial forecasts, budgets,

management by objectives, operations management techniques and MIS reports that
together provides an integrated system for directing and monitoring organizational
activities. For more details refer to Section 6.2
2. The four responsibility centers includes:
- cost centers
- revenue centers

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 - profit centers and
- investment centers. Look at Section 6.4.1 for better explanation.
3. Fixed costs are costs, which are based on commitment from a prior budget period and
cannot be changed. Variable costs are often called engineered costs, are based on explicit
physical relationship with the volume of departmental activity. While Discretionary costs
are based on management decisions. They are not based on a fixed, long term
commitment or on the volume of items produced, based on a fixed, long term commitment
or on the volume of item produced, because discretionary costs cannot be calculated with
precision. For more on this, refer to Section 6.4.2.
4. The top-down process has certain advantages:
- Top managers have information on overall economic projections
- They know the financial goals and forecasts and
- They have reliable information about the amount of resources available in the coming
year. For the details refer to Section 6.5.1
5. Signs of inadequate budget control systems have been discussed in brief under Section
6.7 of this unit. For more and detail discussion, refer to that section.

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UNIT 6: GOVERNMENT AND PUBLIC SECTOR BUDGETING

Contents
6.0 Aims and Objectives
6.1 Introduction
6.2 Public Finance
6.3 Fiscal Policy and Public Development
6.4 The Structure of Government Budget
6.4.1 Revenue Budget
6.4.2 Expenditure Budget
6.5 Budget Policy
6.6 Systematic Budget Preparation
6.7 Summary
6.8 Answer to Check Your Progress Exercise

6.0 AIMS AND OBJECTIVES

After studying this unit, you will be able to explain:

- what public finance is
- what fiscal policy is, and
- the structure of government budget.

6.1 INTRODUCTION

When we resort to fiscal policy to combat unemployment or inflation, we are deliberately

tampering with the federal budget. That is what discretionary fiscal policy really is budget
policy.

The federal budget is a statement of the federal government's planned expenditures and
anticipated receipts for the coming year. Whenever unemployment exists (whenever the
unemployment rate is above the natural rate), the federal government should plan a deficit
budget. That is it should plan to spend more than it expects to collect in taxes. By taking this
action, the government infect the economy with additional spending or aggregate demand,

71
that should help drive it toward full employment. Inflationary times call for the opposite
approach, a surplus budget, which expresses the government's intention to spend less that it
expects to collect in taxes. A surplus budget help reduce the amount of aggregate demand in
the economy and thereby moderates inflationary pressures. A balanced budget – a plan to
match government expenditures and tax revenues – is appropriate only when the economy is
operating at full employment, when it has achieved a satisfactory and needs neither stimulus
nor restrains.

6.2 PUBLIC FINANCE

One of the most important policy of the government is fiscal policy, which deals with the
government through tax and non-tax sources and its expenditure. Detailed treatment is given
on this policy. An attempt is also made to explore all possible ways to account for the
different sources that constitute the government revenue. Due consideration is also given to
the component of government expenditure. These expenditures may consist of the
government expenditure. These expenditures may consist of the government spending on
public goods and social services that are usually provided by the government.

The government budget is a financial plan of activities to be performed sometime in the

future. However, in the process of delivering these public goods and social services, the
government may face budgetary deficits when expenditures exceed government revenue, it
looks for ways and means to finance these deficits.

Regardless of the type of economic system that a country follows there is always a
government. However, it may take different forms depending on the political, social and
economic factors. Some economies may have highly centralized government systems while
others may have a decentralized body of governments. Some of the forms of the government
include federal government, regional government and local government.

The duties and responsibilities of the local government may be different from the regional
government and again may be different from that of the federal government. Regardless of the
type and form they take, government usually have some common goal and objectives by and
large. These goals and objectives include the following.

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 1. The maintenance of law and order, so that the property rights can be secured and
economic, social, and political activities can be facilitated.
2. The achievement of macro economic stability, such as: controlling inflation, reducing
unemployment, avoidance of regional imbalances, fair or equitable income distribution,
and promoting economic growth.
3. Adoption of sound economic and social policies, and
4. Provision of public goods (defense and police force, the judiciary, highways, and other
economic infrastructures) and the basic social services (primary education and the health
care services and other social infrastructures).

This involvement become strong and necessary, particularly in the case of the existing
situations of developing countries where the majority of the population is poor and where the
private sector plays relatively minimal role.

6.3 FISCAL POLICY AND PUBLIC DEVELOPMENT

Fiscal policy involves managing the economy through the generation of revenues to discharge
the responsibility of the government by financing expenditures. The role and functions of
fiscal policy in the economy can be outlined in the following ways:

1. The allocation of resources into the production of public and private goods
2. The distribution of income in order to reduce gross inequality; and
3. The promotion of economic growth, and stabilization of economy by reducing
fluctuation in the level of price, output, and employment.

Source of government revenue are divided into tax and non-tax revenue. The principal source
of government revenue is tax revenue. Tax revenue can be further decomposed into direct,
indirect and foreign trade taxes. Direct taxes are taxes levied directly on persons or legal
person entitles in the form of personal income taxes, property taxes, corporate income and
profit taxes and others. Indirect taxes are taxes levied on goods and services. Consumer pay
these taxes indirectly when they buy goods and services. The third category of taxes
constitutes the foreign trade taxes that are levied on imports and exports.

73
The non-tax revenue can be composed of collection of charges such as capital charges and
residual profits, fees, fines, sale of government properties and others.

The expenditure side of public finance may include recurrent and capital expenditure. The
recurrent expenditures include expenditures of wages and salaries of government employees,
pension payments, debt service payments, operating expenses of the government ministries
and other expenses of repeated nature. Capital expenditures contribute to economic growth
and they are targeted towards adding the capital stock of the country. Expenditures of this
type include investment on social and economic infrastructures such as roads and construction
of school and health care faculties.

6.4 THE STRUCTURE OF GOVERNMENT BUDGET

The structure of government budget constitutes the formats in which the budget data are
organized and classified for different purposes. Not only the intentions of the government will
be revealed but also the responsibility of implementing agencies will be clearly indicated in
these formats. The classification of government budget is divided into revenue and
expenditure budget.

6.4.1 Revenue Budget

Revenue budget consists of the annual forecast of government budget from tax and non-tax
sources. In Ethiopia, the annual revenue budget is structured into ordinary revenue, external
assistance and capital revenue.

The direct tax of the ordinary revenue consist of personal income tax, rental income tax,
business income tax, agricultural income tax, tax on dividend and chance winning, land use
fee and lease. The indirect tax is consisting of the excise and sales tax on locally
manufactured goods, service sales tax, stamps on duty. Tax on foreign trade includes customs
duty and excise tax on imported goods, sales tax on imported goods and export tax on coffee.
The revenue budget for the federal government of Ethiopia is prepared by the ministry of
finance (MOF) and for these regional governments by the respective regional finances
bureaus.

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75
 Table 1
Federal Government Expenditure and its Financing
Revenue Budget (Financing)
(A) Domestic Revenue
Tax Revenue 8,588,305,263
Non-Tax Revenue 1,945,304,152
Capital Revenue 359,673,355
Domestic Revenue Total 10,893,282,770
(B) External Assistance
Multilateral Institutions 746,945,350
Bilateral Assistance 579,269,170
Counter Part Fund Assistance 2,474,850,263
HIPC Relief Assistance 819,063,431
External Assistance Total 4,620,128,214
(C) Loans and Credits
Multilateral Institutions 2,142,696,544
Bilateral Loan 0
Counter Part Fund Loan 240,103,500
Loans and Credit Total 2,382,800,044
(D) Domestic Borrowing
1,364,000,000

Total Revenue, Assistance and Borrowing 19,260,211,028

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 6.4.2 Expenditure Budget
The recurrent budget is mostly financed from the domestic revenue source, that is from tax
and non-tax revenues. The capital budget is usually financed by external borrowing and
grants.

Expenditure Budget

Recurrent Capital
Budget Budget

Administrative Economic Other Economic General

Service expenditures Developments Developments
& general
service

Social services Social

Developments

The recurrent budget expenditure consists of expenses that are repeated in nature like salaries
of civil servants. The recurrent budget is structured in Ethiopia under four functional
categories: Administrative and general services, economic services, social services, and other
expenditures. All government bodies fall under either of these categories. For instances,
administrative and general services include such activities as political organs of the state such
as council of representatives and ministers, ministries, defense and so on. The economic
services include such activities under the agricultural, industrial and service sectors. The
social services include such activities as health, education and culture. Other expenditure
include pension payments, repayment of public debts, provision of unforeseen expenses and
similar items. Capital budget expenditure is usually made on the acquisition and
improvements to fixed assets and includes the expenses for consultancy services. The capital
budget is grouped under three headings: economic development, social development, and

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general development. Economic development includes production activities in the agricultural
and industrial sectors, economic infrastructure in mining, road, and energy, commerce and
communication. Social development includes such activities like education, health, urban
development, and welfare.

Table 2
Federal Government Expenditure and its Financing
Expenditure Budget
(A) Recurrent Expenditure Birr Birr
Administration and General Service 3,755,926,900
Economic Service 396,071,700
Social Services 740,080,400
Other Expenditure 8,963,221,000
Domestic Revenue Total 13,855,300,000
(B) Capital Expenditure
General Development 746,945,350
Economic Development 579,269,170
Social Development 2,474,850,263
Other Expenditures 1,007,214,100
Capital Expenditure Total 5,404,911,02
Recurrent & Capital Expenditure Total 19,260,211,028

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 Summary of Revenue and Expenditure Budget
Revenue Budget (Financing)
(A) Domestic Revenue
Tax Revenue 8,588,305,263
Non-Tax Revenue 1,945,304,152
Capital Revenue 359,673,355
Domestic Revenue Total 10,893,282,770
(B) External Assistance
Multilateral Institutions 746,945,350
Bilateral Assistance 579,269,170
Counter Part Fund Assistance 2,474,850,263
HIPC Relief Assistance 819,063,431
External Assistance Total 4,620,128,214
(C) Loans and Credits
Multilateral Institutions 2,142,696,544
Bilateral Loan 0
Counter Part Fund Loan 240,103,500
Loans and Credit Total 2,382,800,044
(D) Domestic Borrowing 1,364,000,000
Total Revenue, Assistance and Borrowing 19,260,211,028
Expenditure Budget
(A) Recurrent Expenditure Birr Birr
Administration and General Service 3,755,926,900
Economic Service 396,071,700
Social Services 740,080,400
Other Expenditure 8,963,221,000
Domestic Revenue Total 13,855,300,000
(B) Capital Expenditure
General Development 746,945,350
Economic Development 579,269,170
Social Development 2,474,850,263
Other Expenditures 1,007,214,100
Capital Expenditure Total 5,404,911,02
Recurrent & Capital Expenditure Total 19,260,211,028

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6.5 BUDGET POLICY

It is the policy of the federal government to have effective budgets that comply with the
financial law/regulations/directives, that comprehensively manage public expenditure, that
link public expenditure to government policy, that limit expenditure to revenue and debt
targets, that promote a balance of capital and recurrent expenditure, that transparently present
items and activities of expenditure, that are prepared systematically according to an
authorized calendar, that are fully funded and promptly disbursed, and that are prepared and
implemented by staff trained in the regulations, principles and practice of budgeting.

Compliance with the financial law, regulations and directives. Budgets will be prepared and
implemented in compliance with the financial law, regulations and directives.

i) Comprehensive management of public expenditure

Proclamation No. 57/1996 "Financial Administration proclamation of the Federal
Government of Ethiopia" stipulates that the budget will comprehensively manage public
revenues and expenditure. The proclamation requires that all public money except those
allowed by law by placed in the consolidated fund and that all disbursement from the
consolidated fund be approved by the council of peoples representatives through an
appropriation. Appropriations will be implemented through the annual budget and through
supplementary budgets as necessary. No expenditure or commitment of expenditure can be
incurred from an appropriation without the approval of the ministry of finance.

ii) Linking public expenditure to government policy

Council of minister's regulation no 17/1997 stipulates that the priorities of the public
investment programs will set the priorities of the capital budget and no capital expenditure
shall be included in the capital budget if it has not been approved by the public investment
program. The civil service reform will expand the public investment program into a public
expenditure program which will comprehensively plan for three years both capital and
recurrent expenditure. The public expenditure program will set the priorities of the capital and
recurrent budget.

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iii) Limiting Expenditure to Revenue and Debt Targets
The ministry of finance will establish the revenue projection for the annual budget.
Expenditure ceiling will be established based on this forecast taking into account policy
largest and external agreements establishing financing limits.

iv) A balance of capital and recurrent expenditure

It is government policy that public expenditures be sustainable. Capital expenditure will have
adequate complimentary recurred expenditure. To promote this balance of capital and
recurrent expenditure, the planning and budgeting reforms of the civil service reform will
improve the linkage between the planning and budgeting of capital and recurrent expenditure.
One reform will be the introduction of cost center budgeting, which will link expenditures
within and between the recurrent and capital budgets to common activity. A second reform
will be the introduction of the public expenditure program that will link capital and recurrent
expenditures and frame the priorities of both the capital and recurrent budgets. A third reform
will be the development of budget norms which link an activity's capital, non-wage recurrent
and salary costs.

v) Transparent Presentation of items and activities of expenditure

It is government policy to strengthen the line item budget and their introduce cost center
budgeting to promote responsibility for inputs and their outputs. Five steps are being taken to
implement these reforms. Once step is to develop a consistent coding of the chart of accounts.
The charts of accounts are the major budget headings used to present the budget.

A second step is to promote consistency in budget categories. Consistent formats should be

used to the extent possible by both the capital and recurrent budgets.

A third step is to link where possible capital and recurrent expenditures on a cost center basis.
Cost centers will allow managers in public bodies to know the total cost of an activity or an
administrative unit and can guide budgeting decisions.

A fourth step is to improve the list of the items of expenditure. Line item budgets are based on
items of expenditure and are designed to control the inputs of expenditure. (Strengthening line

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items budgets require improving the item of expenditure codes so they are consistent, detailed
and transparent.)

A fifth step in improving the budget will be the introduction of work plans for the cost center.
The work plans will link inputs to outputs and will form the bases of a public body's request
for a budget.

6.6 SYSTEMATIC BUDGET PREPARATION

Budgets will be prepared according to an authoritative calendar. The calendar will schedule
the seven phases of budgeting:
1. call
2. request
3. recommendation
4. approval
5. notification
6. operation and
7. execution.

The first phase, call is when the coordinating ministries of finance and planning ask each
public body to prepare a budget request and would provide the budget ceiling for the public
body. The second phase request is when public bodies submit their request for requirement
and capital expenditure to the ministry of finance and the ministry of economic development
and cooperation respectively. The third phase, recommendation, in a review by the ministry of
finance and the ministry of economic development and cooperation of the agency requests
and then a recommendation for each agency based on a recommended ceiling for the total
capital and recurrent budget. The fourth phase, approval, has two stages: Approval by the
council of ministers and approved by the parliament. Phase five is notification where the
ministry of finance and the ministry of economic development and cooperation, notify the
agencies of their approved estimates of revenue and expenditure by class of account and line
item. The six phase of budgeting is operation, which has three tasks:

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 (1) Preparation of action plans for the financial and physical implication which
are submitted to the ministry of finance, the ministry of economic
development and cooperation and the prime minister's office.
(2) The elaboration of these action plans for internal use to implement the budget,
and
(3) The establishment of an operating budget linked to accounts for financial
control. The seventh phase of budgeting is execution which has three tasks: 1)
request and adjustments for transfer and supplementary allocations, 2)
preparation of a monthly report on the financial and physical action plans to
the ministry of finance, the ministry of economic development and
cooperation, and the prime minister's office, and 3) identification of savings
and transfer.

Except for emergencies that require reallocation or delay of appropriated disbursements, or

shortfalls in revenue collection, budgets will be fully funded from the consolidated fund and
promptly disbursed.

Effective implementation of budget procedure required staff who are trained in the
regulations, practice and principles of budgeting. Government has recently trained trainers to
instruct staff in the financial law and regulations. Government is also developing a training
program based on a partnership of federal and regional training institutions that will instruct
staff in current practice and budget principles as well as the new budget procedures of the
civil service reform. Instruction is basic job skills will be delivered by finance and planning
bodies at the federal and regional level. The institutional approach to training reflected in this
strategy of building a partnership between federal and regional training institution will
promote continuity in the instruction of staff and strengthen the capacity of training
institutions to deliver instruction to a large number of federal and regional staff.

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Check Your Progress Exercise?
1. Explain in detail the structure of the Government Budget?
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
2. What is public finance? Explain.
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
3. Explain the seven phases in budget preparation.
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………
4. Explain the components of an expenditure budget.
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………

6.7 SUMMARY

The government budget is a financial plan of activities to be performed sometimes in the

future. However in the process of delivering these public goods and social services, the
government may face budgetary deficits when expenditures exceed government revenue, it
looks for ways and means to finance these deficits.

Fiscal policy involves managing the economy through the generation of revenues to discharge
the responsibility of the government by financing expenditures.

Source of government revenue are divided into tax and non-tax revenue. Tax revenue can be
further decomposed into direct, indirect and foreign trade taxes. The non-tax revenue can be
composed of collection of charges such as capital changes and residual profits, fees, furies,
sale of government properties and others.

84
The expenditure side of public finance may include recurrent and capital expenditure. The
recurrent expenditures include expenditures of wages and salaries, pension payments, etc.
Capital expenditures contribute to economic growth and they are targeted towards adding the
capital stock of the country.

6.8 ANSWER TO CHECK YOUR PROGRESS EXERCISE

1. Refer Section 6.4

2. Refer Section 6.2
3. Refer Section 6.6
4. Refer Section 6.4.2

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UNIT 7: BUDGET PREPARATION – ETHIOPIAN CONTEXT

Contents
7.0 Aims and Objectives
7.1 Introduction
7.2 Banking and Monetary Policy
7.3 The Context of Budget Reform
7.3.1 Decentralization
7.3.2 Fiscal Federalism
7.3.3 Expenditure Assignment
7.4 Budget Administration
7.5 Budget Preparation Process
7.5.1 Budgeting at the Federal Level
[Link] Recurrent Budget
[Link] Capital Budget
7.6 Budgeting at the Regional Level
7.7 Summary
7.8 Answer to Check Your Progress

7.0 AIMS AND OBJECTIVES

After studying this unit, you will be able to explain:

- what budget reform is
- the budget preparation process at federal level, and
- the budget preparation process at regional level.

7.1 INTRODUCTION

The working definition made by the World Bank, Governance refers to the process whereby
elements in society wield power and authority, and influence and enact policies and decisions
concerning public life, economic and social development (World Bank, 1999). For being
effective, fiscal policy implementation requires coordination of political, functional and

86
financial factors. Politically, the institution requires coordination of political, functional and
financial factors. Politically, the institutional incentive structure should promote
accountability and incentives. Functionally, policies should clearly delineate the
responsibilities of each type of government and the private sector in the implementation
process. Financially, policies should be based on a sustainable strategy that relies on long-
lasing sources of revenues. If these three factors coordinated, one can say there is good
governance in that particular country. Decisions about raising fiscal revenues, and planning
and implementing public expenditures take place in the context of a political and incentive
framework influenced by several actors intervening through the process: Ministers,
government institutions and staff, donors providing budgetary support, and civil society, to
the extent that they participate or are given the opportunity to participate in the decision
making forum. Fiscal performance and budget management effectiveness are determined by
how this framework is established. For that reason, before going to evaluate the IPRSP done
by our country, first it is better to look the non-execution factors that led for the
transformation of government budgets. With the ending of the internal arm conflict in the
country, public expenditure was re-oriented towards social and economic development.
Importantly, the share of government recurrent expenditure on education was raised from 11.9
percent in 1998/90 to 17.9 percent in 1996/97, and that of health from 3.5 percent to 5.8
percent. Moreover, emphasis was placed on primary education and health care, to help tackle
poverty at its root.

7.2 BANKING AND MONETARY POLICY

The 1974 revolution brought major changes to the banking system. Prior to the emergence of
the Marxist government, Ethiopia had several state-owned banking institutions and private
financial institutions. The National Bank of Ethiopia (the country's central bank and financial
adviser), the Commercial Bank of Ethiopia (which handled commercial operations), the
Agricultural and Industrial Development Bank (established largely to finance state-owned
enterprises), the Savings and Mortgage Corporation of Ethiopia, and the Imperial Savings and
Home Ownership Public Association (which provided savings and loan services) were the
major state-owned banks. Major private commercial institutions, many of which were foreign

87
owned, included the Addis Ababa Bank, the Banco di Napoli, and the Banco di Roma. In
addition, there were several insurance companies.

In January and February 1975, the government nationalized and subsequently reorganized
private banks and insurance companies. By the early 1980s, the country's banking system
included the National Bank of Ethiopia; the Addis Ababa Bank, which was formed by
merging the three commercial banks that existed prior to the revolution; the Ethiopian
Insurance Corporation, which incorporated all of the nationalized insurance companies; and
the new Housing and Savings Bank, which was responsible for making loans for new housing
and home improvement. The government placed all banks and financial institutions under the
National Bank of Ethiopia's control and supervision. The National Bank of Ethiopia regulated
currency, controlled credit and monetary policy, and administrated foreign-currency
transactions and the official foreign-exchange reserves. A majority of the banking services
sere concentrated in major urban areas, although there were efforts to establish more rural
bank branches throughout the country. However, the lending strategies of the banks showed
that the productive sectors were not given priority. In 1988, for example, about 55 percent of
all commercial bank credit financed imports and domestic trade and services. Agriculture and
industry received only 6 and 13 percent of the commercial credit, respectively.

To combat inflation and reduce the deficit, the government adopted a conservative fiscal
management policy in the 1980s. The government limited the budget deficit to an average of
about 14 percent of GDP in the five years ending in EFY 1988/89 by borrowing from local
sources. For instance, in EFY 1987/88 domestic borrowing financed about 38 percent of the
deficit. Addis Ababa also imposed measures to cut back capital expenditures and to lower
inflation. However, price controls, official overvaluing of the birr, and a freeze on the wages
of senior government staff have failed to control inflation. By 1988 inflation was averaging
7.1 percent annually, but it turned sharply upward during 1990 as war expenditures increased
and was estimated at 45 percent by mid 1991.

The Government of Ethiopia under the civil service reform plan has prepared a manual to
describe, analyze and make recommendations for the preparation of recurrent and capital
budgets at the federal and regional level. The manual is intended to be a living document and

88
it is expected that future various will add to and amend earlier versions. The manual is
intended to serve several purposes as described below.

1. Provide a context and detailed assessment of the budget process for making procedural
recommendations for implementation under the civil service reform.
2. Serve as an operational guide to budgeting.
3. Serve as a training resources, and
4. Provide a detailed information source for the partial development of the requirements
documents for the automated financial information system to be implemented under
civil service reform.

7.3 THE CONTEXT OF THE BUDGET REFORM

The central context of budget reform is Ethiopian's ambitious decentralization. Administrative

responsibility has been devoted to regions and within regions administrative responsibility is
being devolved to zones and woredas.

To understand financial administration in Ethiopia one must understand three frame works:
1. decentralization as devolution
2. the functions of public finance especially the allocation role and fiscal federalism, and
3. the assignment of expenditure functions under fiscal federalism.

7.3.1 Decentralization
There are three types of decentralization; deconcentration, devolution and privatization.
Deconcentration is the distribution of administrative functions within a single administrative
hierarchy. For example, a Ministry of Agriculture with region level branch offices reporting to
the ministry headquarters is an example of deconcentration. Devolution is the assignment of
administrative functions to autonomous or semi autonomous administrative hierarchies.
Ethiopia's regional states are an example of devolution. Finally, privatization is the
assignment of public tasks to private or quasi-private agencies. Privatizing the provision of
health or education would be an example of this decentralization.

While the pattern of decentralization in Ethiopia context is complex, varied and uneven
devolution is the dominant type. Devolved decentralization has the following attributes.

89
  The fundamental characteristic of devolved administrative systems is an evolving
partnership between administrative levels; federal to regions, region to sub regions.
 Partnership is build both by the reform processes and products, which promote
discretion by local authorities.
 Effective discretion requires capacity and accountability.
 The goal of devolution is increased discretion, which requires the capacity to exercise
discretion and political and administrative accountability.
 Implementation dilemma: how to make progress in building the partnership in a
reasonable time frame while paying attention to both process and product etc.

7.3.2 Fiscal Federalism

Placing the decentralization framework into a financial framework raises the three functions
of public finance: stabilization, distribution and allocation. Public finance holds that the
stabilization function (managing monetary aggregates) should be centralized. The distribution
function which is to promote equity in resources has traditionally been viewed as a centralized
financial function though in recent years strong arguments have been raised that this function
can be decentralized. The use of formulas to assign subsidies between sub regional levels in
Ethiopia supports the argument that the distribution function can be decentralized. The
allocation function of public finance is the distribution of goods and services and it is broadly.
The body of financial theory explaining the decentralized allocation function is called Fiscal
Federalism. Fiscal federalism is the financial framework of decentralization.

Fiscal Federalism has five principles.

1. Local management of resources responds better to local preferences.
2. It may be more efficient to assign expenditures to the lowest level of government
consistent with efficient performance.
3. Administrative levels are accountable to local tax payers and accountable to the
administrative levels above which transferred the funds.
4. Fiscal equalization
5. Increases the stake in the process by local institutions and individuals.

90
The essence of fiscal federalism is improved management of resources through decentralizing
discretion to the lowest level where it can reflect preferences and be held accountable. The
central design issue of fiscal federalism is where to assign expenditure authority.

7.3.3 Expenditure Assignment

The central task of fiscal federalism is the assignment of discretion over expenditure. A
framework for assigning expenditure functions is therefore needed. In budgets there are two
areas of discretion: how allocations are made and how costs are determined.

1. Allocations: there are types of allocations. Allocating a budget ceiling and allocating
from a budge ceiling. A ceiling is an overall sum from which allocations are made. In
some cases one level allocates a ceiling to another level and in other cases one level
specifies detailed expenditure items to another level.

Both these types of allocation decision may be:

a) arbitrary and subject to negotiation
b) governed by norms, standards, or formulate and therefore not arbitrary
c) based on last year's allocation.

The allocation criteria need to be specified and analyzed to determine whether they are
reflected in the budget and later in expenditures.

2. Costs: although allocation decision may be made at a given levels, these may be
constrained. They may be constrained by legislation, regulations and by other types of
policy. They are also constrained by the degree to which at any given level there exists
choice about costs. The "top" may set in place direct constrains (laws, regulations etc) and
indirect constraints (the fixing of cots, e.g., national salary scale). Thus, although there
may be some discretion over allocation, there may be less discretion over costs.

3. Policy: A budget is a financial expression of a policy. An annual budget reflects the

planning of expenditures for that year. Allocations therefore are /should be based on the
achievement of a given policies (e.g., increased enrollment, improved quality).

91
7.4 BUDGET ADMINISTRATION

PROCLAMATION NO. 358/2003

FEDERAL GOVERNMENT BUDGET PROCLAMATION
WHEREAS, it has become necessary to approve and disburse on time the budgetary
appropriation for undertakings by the Federal Government during the 1996 (E.C) Fiscal
Year.

WHEREAS, the subsidy budget that may be appropriated to the Regions has to be decided on
the basis of the formula developed by the House of Federation;

NOW, THEREFORE, in accordance with Article 55(1) and (10) of the Constitution of the
Federal Democratic Republic of Ethiopia, it is hereby proclaimed as follows:

PART I
General
Article 1: This Proclamation may be cited as the "1996 Fiscal Year Budget Proclamation No.
358/2003."
Article 2: The Federal Budget is hereby appropriated for the fiscal year commencing on
Hamle 1,1995 E.C and ending on Sene 30, 1996 E.C. from Federal Government
revenues and other funds for the undertakings set forth in the Schedule hereto:

(a) For Recurrent Expenditure Birr 7,885,500,000

(b) For Capital Expenditure Birr 5,404,911,028
(c) For Subsidy Appropriation to regions Birr 5,969,800,000
Grand Total Birr 19,260,211,028

(Ninetteen Billion Two Hundred Sixty Million Two Hundred Eleven Thousand Twenty Eight
Birr).

Article 3: The Ministry of Finance and Economic Development is hereby authorized to grant
advance of salary to permanent Federal Civil Servants for necessary cases in
accordance with directives issued thereon, and to fix the period of repayment

92
 thereof, and to collect interest thereon, at the rate fixed by the directives to be
issued by the Minister of Finance.

PART II
BUDGET ADMINISTRATION
Article 4: Powers of the Federal Government Organs
1) The Minister of Finance and Economic Development is hereby authorized and
directed, upon the request of the heads of the concerned Federal Government organs,
to disburse out of the Federal Government revenues and other funds the amounts
appropriated herein for undertakings of their respective organs.
2) The Minister of Finance and Economic Development is hereby authorized to allow
Federal Government Hospitals, to retain and expend within their total budgetary
appropriations, receipts from the current fiscal year up to an amount not exceeding
50% (Fifty percent) of their receipt for the previous fiscal year.
3) Public bodies are hereby authorized to record on their appropriate budgetary head,
subhead, project, or program, as the case may be, and undertake all acts necessary for
the utilization of any additional loan or aid in kind and/or cash obtained from foreign
or local sources for carrying out capital project or recurrent programs, and report to the
Minister of Finance and Economic Development within one month from the end of the
budget year.
4) The Ethiopian Customs Authority shall assess and record duties and taxes payable on
goods imported by public bodies, purchased with the proceeds of loans, or grants and
appropriated from the treasury or acquired in kind, and allow such goods to enter into
the country. The Authority shall notify the assessment, thus recorded to the public
body concerned.
5) If the agreement signed between the consultant and the project executing public body
stipulates that the income tax and the service sales tax payable by the public body, the
same shall inform the Federal Inland Revenue Authority. The federal Inland Revenue
authority shall on the basis of information it obtained from the public body keeps
record of such taxes. The authority shall also notify the public body of such record.

93
 6) The Public Body, which received the notification, mentioned under sub-Article 4 and
5 above shall record the amount of taxes and duties under its heading; sub-heading,
program, project and shall, within one month from the end of the budget year,
communicate to the Ministry of Finance and Economic Development the Taxes and
duties payable on goods for which budget from the payment of the tax not already
been appropriated.
7) The Ministry of Finance and Economic Development is further authorized and
directed to record as supplementary appropriation the additional loan or aid in kind
and/or in cash recorded pursuant to Sub-Article (3) and (6) of this Article.
8) The Minister of Finance and Economic Development is hereby authorized to set-up
special fund to be financed out of the proceeds of foreign loans and assistance
obtained for the reconstruction of infrastructures and other properties destroyed in the
course of Ethio- Eritrean conflict and to demobilize a portion of the defence force in
order to reduce its size to peace time requirements and to rehabilitate the demobilized
members of the force in a special program.
9) The Minister of Finance and Economic Development shall issue directive outlining
conditions under which the fund setup in accordance with Sub-Article 8 shall be
administered.

Article 5: Budget Transfer

Without prejudice to the provisions of Article 17-20 of the Federal Government of Ethiopia
Financial Administration Proclamation No. 57/1996 budget transfer shall be executed as
follows:
1) Where a budget is required to finance pending obligations of a project approved in
previous years, such budget shall be allocated in the following manner:
a. If the budget can be covered by transfer from the capital budget of the public
body, such transfer may be authorized by the Ministry of Economic
Development and Co-operation.
b. If the budget can be covered within the overall capital budget ceiling by
transfer of capital budget of one public body to the other, such transfer may be
authorized by the Council of Ministers on the basis of the recommendations
submitted by the Ministry of Economic Development and Co-operation.

94
 2) Transfer of recurrent budget from one public body to the other can be made upon
authorization of the Council of Ministers.
FEDERAL GOVERNMENT
SUMMARY OF REVENUE, EXTERNAL FUNDS AND DOMESTIC LOAN SUMMARY

Birr Birr
(A) Domestic Revenue
Tax Revenue 8,588,305,263
Non-Tax Revenue 1,945,304,152
Capital Revenue 359,673,355
Domestic Revenue Total 10,893,282,770

(B) External Assistance

Multilateral Institution 746,945,350
Bilateral Assistance 579,269,170
Counter Part Fund Assistance 2,474,850,263
HIPC Relief Assistance 819,063,431
External Assistance Total 4,620,128,214

(C) External Loan

Multilateral Institutions 2,142,696,544
Bilateral Loan -
Counter Part Fund Loan 240,103,500
External Loan Total 2,382,800,044

(D) Domestic Loan 1,364,000,000

Total 19,260,211,028

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7.5 BUDGET PREPARATION PROCESS

7.5.1 Budgeting at the Federal Level

The recurrent budget is not defined in the financial law or the financial regulations. The
financial law does provide a definition of the capital budget thereby residually defining the
recurrent budget. There is considerable uncertainty amongst budget staff as to what
expenditures should be placed in the recurrent or capital budget. The financial law defines the
items of expenditure for the capital budget as fixed assets or consultancy services.

Analysis of recurrent budgets though show that fixed assets which are not associated with an
external assistance project are frequently budgeted in the recurrent budget. It is also not clear
how to budget those externally financed projects which build capacity (training, technical
assistance) as opposed to those that install or build fixed assets.

There are a variety of criteria that can be used in defining recurrent and thus capital budgets.
The three most common are source of finance (domestic, external), status of expenditure
(project versus program), and object of expenditure (fixed asset, consultancy service, etc).
The financial law has defined the budget through the object of expenditure making the
recurrent budget residual to the definition of the capital budget.

The recurrent budget at the federal level, which consolidates and coordinates the recurrent
budgets of all Federal Public spending bodies, is prepared by the budget department of the
ministry of finance.

The Ministry of Finance are authorized by the Federal Government during the 1996 (G.C)
fiscal year under the proclamation No 358/2003. Some of the authority issued to MOF are
quite illuminating and worth discussing.

Article 3 of proclamation no 358/2003 states that: The Ministry of Finance and Economic and
development is here by authorized to grant advance of salary to permanent federal civil
servants for necessary cases in accordance with directives issued thereon, and to fix the
period of repayment thereof, and to collect interest thereon, at the rate fixed by the directives
to be issued by the Ministry of Finance.

96
[Link] Recurrent Budget
FEDERAL GOVERNMENT
RECURRENT BUDGET
Description Recurrent Budget
1 2
TOTAL 7,885,500,000.00

ADM. & GEN. SERVICE 3,755,926,900.00

Organs of State 76,548,300.00
Justice and Public Order 223,982,800.00
National Defence 3,000,000,000.00
General Services 455,395,800.00

Economic Service 396,071,700.00

Agric. And Natural Resources 110,093,600.00
Water Recourses 29,521,300.00
Industry and Trade 73,655,700.00
Mining and Energy 31,550,600.00
Transport and Communication 120,535,700.00
Construction 30,714,800.00

Social Service 740,080,400.00

Education Trading 586,671,200.00
Culture and Sport 27,887,800.00
Health 74,642,900.00
Labor and Social Affairs 26,644,800.00
Prevention and Rehabilitation 24,233,700.00

Other Payments 2,993,421,000.00

Transfer 10,507,600.00
Regional Subsidy
Public Debts 2,411,000,000.00
Provisions 369,200,000.00
Others 202,713,400.00

97
The budget preparation process is as enumerated below:
Preparation of Recurrent Budget in the MOF

Preparation of the macro framework

Allocating public expenditure between the

federal and regional governments

Allocating between recurrent and capital

budget at federal level

Budget call and ceiling notification by

ministry of finance

Submission of the budget proposal to the

ministry of finance

Budget hearing with the ministry of

finance

Review and recommendation by ministry

of finance

Submission to the council of ministers

Submission to the council of peoples'

representatives

Notation and publication

1. Preparation of the Macro Framework

Allotment
Allotment

98
This is an assessment of the economic situation and establishment of fiscal balance (GDP,
growth rate, etc). This stage includes two steps:
a) collecting and analyzing information regarding the performance of
the economy in the previous fiscal years,
b) economic protection such as growth, revenue estimating for the next
year which is done by the coordinating ministries (ministry of economic development
and cooperation and ministry of finance) with consultation with the National Bank of
Ethiopia, the central statistics authority and other relevant institutions. The macro
framework is reviewed and approved by the prime minister's office.

2. Allocating Public Expenditures Between the Federal and Regional Government

This step determines the amount of subsidy to regional governments. After preparing the
revenue estimation of total government expenditure (fiscal plan) a decision usually is made by
prime minister's office for allocating the shares to the federal and regional governments. The
distribution among regions is done by the Federation council with consultation of the Prime
Minister's office, Ministry of Economic Development and Cooperation, and Ministry of
Finance. Allocation between regions is based principally upon a formula, such as population,
level of development, revenue generation capacity. The price minister's office reviews the
split and then presents to the federation council.

3. Allocating Between Recurrent and Capital Budget at Federal Level

Depending on various factors, the PMO with consulation of ministry of economic
development and cooperation and the ministry of finance determines how much is to be
allocated to recurrent and capital expenditure. The decision is based on the following factors:
a) government prioritized sectors
b) non-discretionary expenditures
c) on going projects, and
d) institutional capacity

99
4. Budget Call and Ceiling Notification by the Ministry of Finance
The ministry of finance provided each spending public body a recurrent ceiling in the budget
call.
a) The ministry of finance prepares a proposal for the total recurrent
budget and allocations to spending public bodies.
b) The prime minister's office reviews the ministry of finance's proposal
and makes adjustment.
c) The ministry of finance releases the budget ceiling to the line
ministries in a budget call.
d) The budget call provides each ministry the following information: the
macro economic environment, an aggregate recurrent budget ceiling, and priorities
to budget.

5. Submission of the Budget Proposal to the Ministry of Finance

Prior to a formal budget hearing, spending public bodies submit their budget proposals to the
ministry of finance. The budget submission is given to the budget department of the ministry
of finance for study. The ministry of finance prepares an issue paper on the major issues at
each head level in the proposed budget. Spending public bodies can submit above the ceiling
but have to have a compelling justification for a higher ceiling such as new priority activity.

6. Budget hearing with the Ministry of Finance

Spending public bodies defend their budget submission in a formal hearing with the ministry
of finance. The budget hearing includes ministers and/or vice ministers, heads of public
bodies and relevant department heads and budget experts from the spending public bodies and
their ministry of finance.

Spending public bodies can challenge the ceiling at the budget hearing. The heading focuses
on policies, programs, and cost issues.

100
7. Review and Recommendation by the Ministry of Finance
The budget committee of the ministry of finance reviews the discussion and make a
recommendation. If there is an increase in the spending public body's ceiling this has to go to
the prime minister's office for approval. Usually the ministry of finance recommends the
budget to the council of ministers.

8. Submission to the Council of Ministers

The recommended budget is submitted to the Deputy prime ministers in economic affairs
summon individuals from each ministry as required. Once reviewed, the budget is then
presented to the prime minister along with a brief. The prime minister may or may not make
amendments and then the budget is sent to the council of ministers for discussion.

9. Submission to the Council of Peoples' Representatives

Once approved by the council of ministers, the prime minister presents both the capital and
recurrent budgets to the council of peoples' representatives. The budget committee of the
council reviews and makes recommendations to the council.

10. Notification and Publication

The budget is appropriated by the council of peoples' representatives and is published in the
Negaret Gazeta. Spending public bodies are formally notified of their budget for the next
financial year by the release of Form 3/1 from the ministry of finance. Until Form 3/1 is
received, spending public bodies are authorized to spend one-twelfth of the previous years
budget with no provision for new expenditures (e.g., new staff posts). Form 3/1 is sent to the
Treasury Department of the ministry of finance which disburses funds to spending public
bodies.

11. Allotment
The public bodies are required to prepare salary allotment, work plan and cash flow and
submit to the ministry of finance. The allotment is verified by the ministry of finance and then
sent to the treasury department along with Form 6 which authorizes the disbursement.

101
[Link] Capital Budget
Ethiopia has a dual budget system with capital and recurrent budgets prepared separately by
planning and finance institutions respectively. The budget preparation process calendars of
recurrent and capital budgets are different. The process of budgeting begins with the federal
coordinating ministries (ministry of finance and ministry of economic development and
cooperation), which determines the budget ceiling for federal spending public bodies and the
grants to the regions. The ministry of economic development and cooperation prepares the
grant formula, which the prime minister's office uses to issue the regional grants. The ministry
of economic development and cooperation also issue the capital budget ceiling for the federal
spending public bodies. The ministry of finance issues the recurrent budget ceiling to the
federal spending public bodies.

A capital budget is broadly describes as an outlay on projects that results in the acquisition of
fixed assets and the provision of development services. The financial law defines capital
expenditure as the "outlay of the acquisition of or improvements to fixed assets, and includes
expenditures made for consultancy services." Such outlays include: expenditure on physical
and social infrastructure, machinery and equipment, research studies and design,
management, supervision and direct labor costs, transfer payments like taxes related to
projects. The concept of a capital budget has therefore a wider coverage than simple outlays
in fixed investments, since it includes expenditure on development services like agricultural
research and transfer payments related to a project.

The capital budget is presented in two ways: by economic category and by appropriating
agency by code of expenditure. Individual projects are detailed under such sectors as
"agriculture development", "road construction" and the like. Project activities are further
codified by items of expenditure.

Currently the composition of capital expenditure in Ethiopia tends to increasingly shift

towards expenditure on physical infrastructure, which is an element of the economic
development category and the social infrastructure, which is included in the social
development category. This allocation is mainly due to the low level of the existing
infrastructure development which cannot be left to the private sector.

102
Preparation of the capital budget involves seven distinct stages with some reiteration
whenever there is a need.
FEDERAL GOVERNMENT
CAPITAL BUDGET
Description Capital Budget
1 2
TOTAL 5,404,911,028.00

ADM. & GEN. SERVICE 188,063,500.00

Organs of State 68,861,800.00
Justice and Public Order 24,783,200.00
National Defence
General Services 94,418,500.00

Economic Service 3,401,311,638.00

Agric. And Natural Resources 637,869,387.00
Water Recourses 159,914,750.00
Industry and Trade 29,815,575.00
Mining and Energy 105,911,926.00
Transport and Communication 32,087,000.00
Construction 2,435,713,000.00

Social Service 808,321,790.00

Education Trading 761.632,140.00
Culture and Sport 14,965,400.00
Health 30,518,000.00
Labor and Social Affairs 98,000.00
Prevention and Rehabilitation 1,108,250.00

Other Payments 2,993,421,000.00

Transfer 1,007,214,100.00
Regional Subsidy
Public Debts
Provisions
Others

103
The brief description of the federal capital budget preparation procedures are as illustrated
below:

Preparation of the Capital Budget

Preparation of the macro framework

Allocating public expenditures between

the federal and regional government

Allocating between recurrent and capital

budget at federal level

Capital budget call

Capital budget review

Capital budget hearing and defense

Submission to the council of ministers

Submission to the draft capital budget to

the council of peoples' representatives

Notification and publication of the capital

budget

104
1. Preparation of the Macro Framework
This is an assessment of the economic situation and establishment of fiscal balance (GDP,
growth rate, etc). This stage includes two steps: collecting and analyzing information
regarding the performance of the economy in the previous fiscal years, economic protection
such as growth, revenue estimating for the next year which is done by the coordinating
ministries (ministry of economic development and cooperation and ministry of finance) with
consultation with the National Bank of Ethiopia, the central statistics authority and other
relevant institutions. The macro framework is reviewed and approved by the prime minister's
office.

2. Allocating Public Expenditures Between the Federal and Regional Government

This step determines the amount of subsidy to regional governments. After preparing the
revenue estimation of total government expenditure (fiscal plan) a decision usually is made by
prime minister's office for allocating the shares to the federal and regional governments. The
distribution among regions is done by the Federation council with consultation of the prime
minister's office, ministry of economic development and cooperation, and ministry of finance.
Allocation between regions is based principally upon a formula, such as population, level of
development, revenue generation capacity. The price minister's office reviews the split and
then presents to the federation council.

3. Allocating Between Recurrent and Capital Budget at Federal Level

Depending on various factors, the PMO with consultation of ministry of economic
development and cooperation and the ministry of finance determines how much is to be
allocated to recurrent and capital expenditure. The decision is based on the following factors:
a) government prioritized sectors
b) non-discretionary expenditures
c) on going projects, and
d) institutional capacity

105
4. Capital Budget Call
Each year the ministry of economic development and cooperation issues detailed capital
budget preparation guidelines to the federal government spending public bodies along with
the ceiling provided to each line institution. The overall national ceiling is decided by the
prime minister's office (with a background proposal from ministry of economic development
and cooperation).

Sectoral ceiling are usually issued immediately following the decision on national ceiling. The
objective of the budget call is to receive a capital budget proposal at a fixed date from
spending public bodies. Federal spending public bodies submit a budget proposal by code of
expenditure and source of finance each year.

5. Capital Budget Review

The sector departments of the ministry of economic development and cooperation review the
capital budget requests from different public bodies. At this stage projects are screened. If
there exists a discrepancy between the respective sector department and the public body, a
series of discussions are held to reach agreement. The various departments of the ministry
submit their first round recommendation to the development finance and budget department
of the ministry. The information capital budget steering committee (members drawn from
prime minister's office and the ministry of economic development) receives the consolidated
federal capital budget through development finance and budget.

6. Capital Budget Hearing and Defense

Federal spending bodies are called to defend their projects to a budget hearing convened by
the prime minister's office which is chaired by the prime minister or the deputy prime minister
or their economic advisor. The hearing customarily include a review of the following:
i. status of projects
ii. implementation capacity of the institution involved
iii. compatibility with the country's development strategy and policy
iv. cost structure
v. regional distribution.

106
A project description is presented at the hearing, which includes the following: objectives of
the project; main activities of the project; status of the project, total costs, past performance of
the project, structure of finance, whether the project is accepted or rejected by the sector.

The budget hearing focuses on whether to accept or reject a project during the up coming
fiscal year.

7. Submission to the Council of Ministers

The ministry of economic development and cooperation receives the capital budget
requirement of each institution, which is finally recommended by sector departments.

A brief analysis of the federal capital budget is prepared by the ministry along with a
consolidated federal capital budget is submitted to a meeting of the council of ministers called
by the prime minister. The ministry defends the budget to the council. The council of
ministers may make some adjustments and finally the draft capital budget passes the first
stage of approval.

8. Submission of the Draft Capital Budget to the Council of Peoples'

Representatives
The final draft federal capital budget is submitted through the council of ministers to the
council of peoples' representatives for discussion and final approval.

9. Notification and Publication of the Capital Budget

The final stage in capital budget preparation is notifying the line budgetary institutions of
their approved capital budget by items of expenditure through the ministry of economic
development and cooperation. The legal status of the capital budget is established through
publication in the "Negarit Gazeta".

107
 FEDERAL GOVERNMENT
summary of expenditure
Description Recurrent Budget Capital Budget Subsides Total
1 2 3 4 5
TOTAL 7,885,500,000.00 5,404,911,028.00 5,969,800,000.00 19,260,211,028.00

ADM. & GEN. SERVICE 3,755,926,900.00 188,063,500.00 - 3,943,990,400.00

Organs of State 76,548,300.00 68,861,800.00 145,410,100.00
Justice and Public Order 223,982,800.00 24,783,200.00 248,766,000.00
National Defence 3,000,000,000.00 3,000,000,000.00
General Services 455,395,800.00 94,418,500.00 549,814,300.00

Economic Service 396,071,700.00 3,401,311,638.00 - 3,797,383,338.00

Agric. And Natural Resources 110,093,600.00 637,869,387.00 747,962,987.00
Water Recourses 29,521,300.00 159,914,750.00 189,436,050.00
Industry and Trade 73,655,700.00 29,815,575.00 103,471,275.00
Mining and Energy 31,550,600.00 105,911,926.00 137,462,526.00
Transport and Communication 120,535,700.00 32,087,000.00 152,622,700.00
Construction 30,714,800.00 2,435,713,000.00 2,466,427,800.00

Social Service 740,080,400.00 808,321,790.00 - 1,548,402,190.00

Education Trading 586,671,200.00 761.632,140.00 1,348,303,340.00
Culture and Sport 27,887,800.00 14,965,400.00 42,853,200.00
Health 74,642,900.00 30,518,000.00 105,160,900.00
Labor and Social Affairs 26,644,800.00 98,000.00 26,742,800.00
Prevention and Rehabilitation 24,233,700.00 1,108,250.00 25,341,959.00

Other Payments 2,993,421,000.00 1,007,214,100.00 5,969,800,000.00 9,970,435,100.00

Transfer 10,507,600.00 1,007,214,100.00 1,017,721,700.00
Regional Subsidy 5,969,800,000.00 5,969,800,000.00
Public Debts 2,411,000,000.00 2,411,000,000.00
Provisions 369,200,000.00 369,200,000.00
Others 202,713,400.00 202,713,400.00

108
7.6 BUDGETING AT THE REGION AND SUB-REGION LEVELS

To reduce regional disparities among regions, government provides an incentive package

scheme to investors to encourage them to invest in the backward regions. Thereby economic
development will be fostered. In addition to this, government appropriately allocate budget
subsidies to all regions depending upon their infrastructure need: schools, road, electricity,
hospitals, etc.

The factors necessary to allocate funds to regions are worth discussions.

 The Objective of Budget Subsidy

To ensure rapid economic development, authority has to be decentralized at region and sub
region level in order to encourage them to determine their budget requirement. Accordingly,
the federal government will provide a general purpose grant and specific purpose grant.
Therefore, the main purpose of the General Grant is:

(C) To assist regions and sub regions expenditures on which case they are unable to cover.
(D) To assist regions and sub regions on laying an infrastructure in order to normalize the
regional disparities.
(E) The purpose of the general grant is indicative. On one hand, it works in normalizing the
horizontal fiscal imbalance and to maintain efficiency in allocation.

A. Type of Grant and Fiscal Transfer

1. When revenue is unable to cover the expenditure, it may jeopardize the activities of
the regions. In such instances, grant without a question is necessary. In this case, either
specific purpose grant or general purpose grant will be a mandate.
2. General Purpose Grant: will provide full authority to the user as to allocate the grants
based up on their expenditures priority.
3. Specific Purpose Grant: in this grant, expenditures are predetermined. Whereby the
regional government or the federal government will impose on regions to see to it that
they are implemented as per plan.

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B. Expenditure and Revenue Equalization
The regions in order to meet their expenditure assignment they should have a financial
strength (Revenue or Financial Resource). In order to have a clear picture as to surplus and
deficit, the regions must laid an equalization system in order to monitor their performances.

Indicators of Budget Size

To determine the budget requirements of the regions and sub regions, certain factors needed
be considered. The following factors are quite illuminating:
1. Population
Every economic plan should be based up on the population. The planner must center the total
number of population. The planner must center the total number of population, the birth rate,
economic concentration, housing etc while planning, this variable must be considered, and
accordingly the budget need will be determined.

2. Expenditure Requirements
While determining their expenditure requirements, region and sub regions must compare their
regions with others in view of the economic development. That is, backward regions must
assess the budget size requirement according to the activities that they are intending to take.

3. Agriculture
Agriculture is the backbone of the regional economy. In assessing of the budget size, the
agricultural development of the region is indicator while assessing the development, the
following factors needed to be considered:
i. workforce(development agent)
ii. number of a household in extension package program
iii. number of veterinary clinics

4. Health
Health sector development program must consider the primary health care – curative as well
as preventive. While trying to foster the health economy, the planner must look on to the
following variables.

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 A. Number of Health Center
 Number of health center/ thousands of population
 Number of clinics/ thousand population etc
B. Health Professionals
 Number of Doctors/ thousand population
 Number of Nurses/ thousand population
 Number of Laboratory Technicians/ thousand population

5. Education
The other factor to be consider while budget is the education center. The regions must
compare the level of education compared to the other regions before determining the budgets.
The factors to be work under this is:
A. Number of primary schools
B. Correlation between students and teachers
C. Class size of the primary school etc

6. Water
Water supply is one of the basic need that a human being requires to live. To avoid water
cause diseases, regions must work in supplying pure water to their fellow citizens.
Accordingly, they must work on the need assessment of water supply etc.

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Federal Government Subsidies to Regions

Tigray Region 458,150,000

Afar Region 224,990,000
Amhara Region 1,335,050,000
Oromia Region 1,846,610,000
Somale Region 372,040,000
Benshangul-Gumuz Region 175,510,000
SNNP Region 1,138,920,000
Gambella People Region 130,580,000
Harari People Region 77,520,000
Addis Ababa City Administration 122,520,000
Dire Dawa Administration Council 85,910,000
Total 5,969,800,000

Source: Federal Government Budget Proclamation No. 358/2003

Regions and sub regions will have to take the various factors discussed above, while
submitting their budget proposal. According to their economic development, and the budget
requirement, the federal government may endorse the amount of subsidies granted to them.

Procedures to Prepare Budget at Region and Sub-region Level

The procedures followed to prepare the budget at region and sub-region levels follow the
series of steps which are as follows.

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1.
Preceiling budgeting by woredas

Review of woreda pre-ceiling budges by

zones

Review of zone pre-ceiling budgets by

regions

Determination of the regional expenditure

envelop

Allocation of the regional between capital

and recurrent expenditure

Allocation to bureaus and zones

Allocation to zone sector department

Allocation to woreda

1. Pre-ceiling Budgeting by Woredas

The woredas prepares a budget with no indicative or final ceiling from the zone or the region.
There is no ceiling yet from the zone or the region because the federal government has not yet
notified them of their grant, which covers approximately 85% of ther regional expenditure.
The woreda sector office prepares a budget. The woreda executive committee forms a budget
committee to review the budget submission.

2. Review of Woreda Pre-ceiling Budgets by Zones

The woreda budgets are sent to the zone through two channels. The woreda executive
committee submits to the zone executive committee and the woreda sectoral offices send to

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the zone sectoral departments. The executive committee will set up a budget committee which
reviews the woreda and one sectoral budget submissions.

3. Review Zone Pre-ceiling Budgets by Regions

The zone budgets are sent to the region through two channels. The zone executive committee
submits to the region sectoral bureaus. The sectoral bureaus then prepare a budget submission
to the region plan bureau. The sectoral bureau can change the budget submission from the
zone. The submission is the combined budget of the sectoral bureaus, departments and
offices.

4. Determination of the Regional Expenditure Envelop

The region is notified of the federal grant between March and May. The total regional public
expenditure envelope is then determined based on the federal grant, local revenue and local
borrowing.

5. Allocation of the Region Envelop Between Capital and Recurrent Expenditure

The region allocates the expenditure envelop between capita and recurrent. The allocation
begins with recurrent expenditure specifically non-discretionary expenditure expenditures
(debt, legal liabilities, pension, salary). The largest share of recurrent expenditure is for salary
and the region can determine this total because all staff are managed from the region level.
The balance of the envelop or the upper bound residual of he expenditure envelop is reserved
for capital expenditures. The trend shows that government emphasizes capital expenditure.

6. Allocation to Bureaus and Zones

The capital envelope is allocated to the region bureaus by increment. First, the share of
ongoing projects, inter-regional projects and those projects administrated by bureaus at zone
and woreda level and included first.

7. Allocation to Zone sector Departments

In this step, the lump sum zone allocation is distributed by sector to the corresponding zone
and woreda departments and offices. Once the sahre of the zonal allocation is known the
sectoral budget allocation is made by the following criteria: ongoing projects, new priority
projects, the 5-year plan and inter-zonal projects.

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8. Allocation to Woredas
The woreda's are allocated on a sectoral basis from the zone. Allocation is done through
discussion by the woreda council with the assistance of two planning officers who are
assigned to the council and experts from the zone who will make allocations to sectroal
offices.

Check Your Progress Exercise

1. What is a budget reform? Explain.
…………………………………………………………………………………………………
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2. What is recurrent budget? Discuss.
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3. Discuss the process involved in budget preparation at the federal level?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
4. Discuss the process involved in budget preparation at the regional level?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

7.7 SUMMARY

Policies should clearly delineate the responsibilities of each type of government and the
private sector in the implementation process.

The central context of budget reform is ambitious decentralization.

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"Decentralization is an outcome of the adoption of a federal system of government in
Ethiopia. With the devolution of power to the regional governments, implementation of
economic policies and development programs have to a large measure, been shifted from the
center to the regions. The application of fiscal federalism ensures a single system of taxation,
allows some revenue collection by the regions and some revenue sharing with the federal
government while putting the majority of the revenue under the central authority, provides
budgetary subvention the regions, and grants the regions full autonomy in budgetary
expenditures.

The recurrent budget at the federal level, which consolidates and coordinates the recurrent
budgets of all budgets of all federal public spending bodies, is prepared by the budget
department of the ministry of finance.

A capital budget is broadly describes an outlay on projects that results in the acquisition of
fixed assets and the provision of development services. The capital budget is presented in two
ways: by economic category and by appropriating agency by code of expenditure. Individual
projects are detailed under such sectors as "agricultural development", "road construction",
and the line. Project activities are further codified by items of expenditure.

7.8 ANSWER TO CHECK YOUR PROGRESS EXERCISE

1. Refer to Section 7.1

2. Refer to Section [Link]
3. Refer to Section 7.5.1
4. Refer to Section 7.6

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