Unit 8: Budgetary Control

Budgetary control is the system by which management sets financial and operational targets in advance, expresses them as budgets, and then measures actual performance against those targets to guide corrective action. It rests on the twin ideas of planning (the budget) and control (the comparison of actual with plan). The Chartered Institute of Management Accountants defines it as the establishment of budgets relating responsibilities of executives to the requirements of a policy, and the continuous comparison of actual with budgeted results.

• Budget: a quantitative statement, prepared before a defined period, of the policy to be pursued for the purpose of attaining an objective.
• Budgeting: the act of preparing budgets.
• Budgetary control: budgeting plus the feedback loop of variance analysis and corrective action.
• Budget period: the time span a budget covers, commonly one year, split into control periods (months or quarters).
• Budget centre: a section of the organisation for which a separate budget is prepared and a manager held responsible.
• Principle of responsibility: every budget is tied to an identifiable executive who controls the relevant costs or revenues.

II. Need and Steps Involved in Budgetary Control

The rationale for adopting the system and the sequence by which it is operated.

A. Need for Budgetary Control

Budgetary control exists to convert broad policy into measurable, controllable targets.

• Planning: forces management to think ahead and set objectives, e.g. a sales target of ₹50 lakh before the year begins rather than reacting to events.
• Coordination: harmonises departments so that production capacity matches the sales forecast and purchasing matches production.
• Control: provides a yardstick; actual spend of ₹1,10,000 against a ₹1,00,000 budget signals a ₹10,000 adverse variance for investigation.
• Communication: budgets convey management's expectations down the hierarchy in numeric form.
• Motivation: attainable targets encourage managers to perform; participation in setting them raises commitment.
• Performance evaluation: results are judged against the budget, isolating efficient and inefficient centres.
• Optimum resource use: scarce cash, materials and labour are allocated to their most productive uses.

B. Steps Involved in Budgetary Control

The system operates as an ordered cycle.

• Establish organisation: prepare a budget manual and appoint a budget committee headed by a budget officer.
• Determine the key factor: identify the constraint (usually sales, sometimes materials or plant capacity) that limits activity; the budget for this factor is built first.
• Prepare functional budgets: build sales, production, materials, labour and overhead budgets around the key factor.
• Prepare the master budget: consolidate functional budgets into a budgeted income statement and balance sheet.
• Compare actual with budget: record actuals for each control period and set them against budgeted figures.
• Compute and analyse variances: measure the gap, classify it as favourable or adverse, and trace its cause.
• Take corrective action: feed findings back to revise operations or, where the budget was unrealistic, revise the budget.

III. Meaning and Types of Budgets

What a budget is and the ways budgets are classified.

A. Meaning of a Budget

A budget is a financial or quantitative plan of operations for a future period, sanctioned before that period begins.

• Forward-looking: it relates to the future, not a record of the past.
• Quantitative: expressed in money, units, hours or ratios so performance can be measured.
• Policy-based: derived from management policy and objectives.
• Comprehensive: covers every function, then consolidates into a master plan.

B. Types of Budgets

Budgets are classified on three bases: time, function and flexibility.

1. Classification by time.

• Long-term budget: covers 5–10 years, used for capital expenditure and R&D planning.
• Short-term budget: covers one year or less, for operating decisions.
• Current budget: covers a very short span (a month), adjusted for current conditions.

2. Classification by function.

• Sales budget: forecast of sales in units and value; the usual starting point.
• Production budget: units to be produced = sales units + desired closing stock − opening stock.
• Materials, labour and overhead budgets: input requirements to meet production.
• Cash budget: forecast of cash receipts and payments (Section IV).
• Master budget: the summarised budgeted profit statement and balance sheet.

3. Classification by flexibility.

• Fixed budget: drawn for a single level of activity and not adjusted if activity changes; useful only when volume is stable.
• Flexible budget: designed to change with the actual level of activity (Section V).

IV. Preparation of Cash Budget

A period-by-period forecast of cash inflows and outflows to manage liquidity.

A. Purpose and Principle

The cash budget shows whether cash will be surplus or deficient in each control period so that borrowing or investment can be arranged in advance.

• Focus on cash, not profit: only actual receipts and payments enter; non-cash items such as depreciation are excluded.
• Timing matters: a credit sale in April collected in June is a June receipt, not an April one.
• Closing balance logic: each period's closing balance becomes the next period's opening balance.

B. Preparation of Cash Budget

The receipts-and-payments method is the common approach.

Opening cash balance
+ Cash receipts (cash sales, collections from debtors,
   interest, sale of assets, loans raised)
- Cash payments (cash purchases, payments to creditors,
   wages, overheads, tax, dividends, capital expenditure)
= Closing cash balance

• Opening balance: cash in hand and at bank at the start of the period.
• Receipts: forecast using collection patterns, e.g. 60% of sales collected in the month of sale, 40% the next month.
• Payments: forecast using payment terms, e.g. creditors paid one month after purchase.
• Financing decision: if the closing balance falls below the required minimum, arrange an overdraft; if it exceeds needs, invest the surplus.

Worked example. Opening balance ₹20,000. Sales: April ₹1,00,000, May ₹1,20,000, collected 60% in the month of sale and 40% the following month. Purchases paid one month in arrears: March ₹50,000, April ₹60,000. Wages ₹15,000 per month.

May receipts:  0.60×1,20,000 + 0.40×1,00,000 = 72,000 + 40,000 = 1,12,000
May payments:  creditors (April) 60,000 + wages 15,000        =   75,000
Opening (May)  = April closing
April: 20,000 + (0.60×1,00,000) - (50,000 + 15,000) = 20,000 + 60,000 - 65,000 = 15,000
May closing  = 15,000 + 1,12,000 - 75,000 = 52,000

• Interpretation: the firm moves from ₹15,000 to ₹52,000, a healthy surplus available for short-term investment.

V. Preparation of Flexible Budget

A budget that recognises cost behaviour and so recasts itself for the actual activity level achieved.

A. Purpose and Principle

A flexible budget separates costs by behaviour so that a meaningful budget can be produced for whatever volume actually occurs, making variance analysis fair.

• Weakness it cures: a fixed budget set for 10,000 units gives a misleading comparison if only 8,000 units are made, because variable costs should have been lower.
• Cost classification is the core:
  • Fixed cost: unchanged in total within the relevant range, e.g. rent ₹20,000 whether 8,000 or 10,000 units are produced.
  • Variable cost: changes in total in proportion to activity, e.g. material at ₹5 per unit.
  • Semi-variable cost: part fixed, part variable, split before budgeting.

B. Preparation of Flexible Budget

The budget is expressed per unit for variable elements and as a lump sum for fixed elements, then extended to each activity level.

Budgeted cost at a level = Fixed cost + (Variable cost per unit × units)
Profit = Sales - Total cost

• Step 1: segregate each cost into fixed and variable components.
• Step 2: compute variable cost per unit.
• Step 3: hold fixed costs constant and scale variable costs to each chosen level (e.g. 70%, 80%, 100% capacity).
• Step 4: compare actual results with the flexed budget for the level actually reached.

Worked example. Selling price ₹20 per unit; variable cost ₹12 per unit; fixed cost ₹40,000. Prepare for 8,000 and 10,000 units.

                        8,000 units      10,000 units
Sales (×20)             1,60,000          2,00,000
Variable cost (×12)       96,000          1,20,000
Contribution             64,000            80,000
Fixed cost               40,000            40,000
Profit                   24,000            40,000

• Interpretation: contribution per unit stays at ₹8, but profit rises faster than volume because fixed cost is spread over more units, illustrating operating leverage.

C. Applications and Limitations

The flexible budget is most valuable where volume is uncertain.

• Applications: seasonal businesses, new ventures with unpredictable demand, and industries subject to swings such as construction.
• Control benefit: isolates cost variances from volume effects, so a manager is judged only on controllable spend.
• Limitations: accuracy depends on correct cost segregation; the linear variable-cost assumption may break down outside the relevant range; and preparation is more laborious than a fixed budget.