Unit 8: Budgetary Control - Subjective Questions

Meaning of Budgetary Control:

Budgetary control is a system of controlling costs which includes the preparation of budgets, coordinating the departments and establishing responsibilities, comparing actual performance with the budgeted figures, and acting upon results to achieve maximum profitability.

According to CIMA, London: "Budgetary control is the establishment of budgets relating the responsibilities of executives to the requirements of a policy, and the continuous comparison of actual with budgeted results."

Need and Importance of Budgetary Control:

• Planning: Forces management to plan ahead and set clear objectives.
• Coordination: Ensures harmony among different departments (production, sales, purchase, finance).
• Control: Provides a yardstick against which actual performance is measured.
• Cost Reduction: Helps in identifying wasteful expenditure and controlling costs.
• Efficiency: Motivates employees by setting targets and measuring achievement.
• Communication: Establishes clear channels of communication of policies.
• Delegation of Authority: Fixes responsibility on individuals for results.
• Optimum Use of Resources: Ensures the best utilization of available resources.
• Profit Maximization: Directs efforts toward achieving planned profit targets.

The main steps involved in the process of budgetary control are:

1. Definition of Objectives: Clearly defining the goals and objectives of the organization to be achieved.

2. Establishment of Budget Centres: Creating sections of the organization for which separate budgets are prepared.

3. Preparation of Organization Chart: Defining the functional responsibilities of each executive.

4. Establishment of Budget Committee: Forming a committee responsible for preparing and coordinating budgets.

5. Preparation of Budget Manual: A document that sets out the responsibilities, procedures, forms, and records related to budgetary control.

6. Determining the Budget Period: Fixing the time period for which the budget is prepared (e.g., one year).

7. Determination of Key Factor (Principal Budget Factor): Identifying the limiting factor (such as sales, material, or capacity) that restricts the organization's activities.

8. Preparation of Budgets: Preparing functional budgets and consolidating them into a master budget.

9. Continuous Comparison: Comparing actual performance with budgeted figures to identify variances.

10. Corrective Action: Taking remedial measures to correct deviations and revising budgets if necessary.

Meaning of Budget:

A budget is a quantitative and financial statement, prepared prior to a defined period of time, of the policy to be pursued during that period for the purpose of attaining a given objective.

According to CIMA: "A budget is a financial and/or quantitative statement, prepared and approved prior to a defined period of time, of the policy to be pursued during that period for the purpose of attaining a given objective."

Essential Characteristics of a Good Budget:

• Expressed in Monetary/Quantitative Terms: Figures should be measurable.
• Prepared in Advance: Based on future policy and estimates.
• Relates to a Definite Period: Covers a specific future time frame.
• Based on Objectives: Directed toward achieving organizational goals.
• Realistic and Attainable: Targets should be achievable yet challenging.
• Flexible: Should be adaptable to changing conditions.
• Participative: Involves all levels of management.
• Supported by Top Management: Requires the commitment of senior executives.
• Clear and Understandable: Easy to interpret by those responsible.

Budgets can be classified on various bases:

1. On the Basis of Time:

• Long-term Budgets: Prepared for periods of 5 to 10 years (e.g., capital expenditure budget).
• Short-term Budgets: Prepared for one year or less (e.g., cash budget, material budget).
• Current Budgets: Prepared for a very short period, adjusted to current conditions.

2. On the Basis of Function:

• Sales Budget: Estimate of expected sales in units and value.
• Production Budget: Quantity to be produced to meet sales and stock requirements.
• Material Budget: Quantity and cost of raw materials required.
• Labour Budget: Labour requirements and costs.
• Cash Budget: Estimate of cash receipts and payments.
• Master Budget: A summary budget incorporating all functional budgets.

3. On the Basis of Flexibility:

• Fixed Budget: Prepared for a single level of activity; does not change with actual output.
• Flexible Budget: Prepared for different levels of activity and changes according to actual output achieved.

The key differences between a Fixed Budget and a Flexible Budget are:

A flexible budget is more useful in situations where sales cannot be accurately forecast, or where the business faces seasonal fluctuations.

Meaning of Cash Budget:

A cash budget is a statement showing the estimated cash inflows (receipts) and cash outflows (payments) over a budget period. It helps in determining the future cash position of a firm and enables management to plan for surplus or shortage of cash.

Objectives of Cash Budget:

• To ensure sufficient cash is available for operations.
• To identify periods of cash surplus for profitable investment.
• To identify periods of cash shortage for arranging finance in advance.
• To maintain proper liquidity and control over cash.
• To coordinate cash requirements with other functional budgets.

Methods of Preparing Cash Budget:

1. Receipts and Payments Method: All expected cash receipts and payments are listed period-wise. This is the most common method used for short-term forecasting.

2. Adjusted Profit and Loss Method: The estimated profit is adjusted for non-cash items (like depreciation) and changes in working capital to arrive at the cash balance. Used for long-term forecasting.

3. Balance Sheet Method: A projected balance sheet is prepared, and the balancing figure represents the cash/bank balance.

Working Note — Collection from Debtors:

• Cash sales = 50% of current month sales
• Credit collection = 50% of previous month sales

Cash Budget (₹)

Explanation:

• April credit collection = 50% of March sales = 50% of ₹40,000 = ₹20,000
• May credit collection = 50% of April sales = ₹25,000
• June credit collection = 50% of May sales = ₹30,000
• Closing balance of each month becomes the opening balance of the next month.

Meaning of Flexible Budget:

A flexible budget is a budget that is designed to change in accordance with the level of activity actually attained. It recognizes the difference between fixed, variable, and semi-variable costs and adjusts the budget to reflect the actual level of output.

According to CIMA: "A flexible budget is a budget which, by recognizing the difference between fixed, semi-variable and variable costs, is designed to change in relation to the level of activity attained."

Situations where a Flexible Budget is More Useful:

• Seasonal Businesses: Where sales fluctuate due to seasons (e.g., woollen goods, cold drinks).
• New Ventures: Where it is difficult to forecast demand accurately.
• Businesses with Changing Demand: Where demand changes due to fashion, tastes, or trends.
• Introduction of New Products: Where sales cannot be reliably estimated.
• General Uncertainty: Where the level of activity cannot be predicted with certainty.
• Industries subject to Government/External Factors: Where output depends on factors like power supply, imports, or labour availability.

A flexible budget allows realistic comparison of actual costs with budgeted costs at the actual level of activity, making it a superior tool for cost control.

Working Notes:

• At 50% capacity, output = 5,000 units, so units per 10% = 1,000 units.
• 60% = 6,000 units; 80% = 8,000 units; 100% = 10,000 units.
• Semi-variable overheads at 50%: Fixed portion = 60% of ₹1,00,000 = ₹60,000; Variable portion = ₹40,000 for 5,000 units = ₹8 per unit.

Flexible Budget (₹)

Observation: As output increases, the total cost rises, but the cost per unit falls because fixed costs are spread over more units.

Advantages of Budgetary Control:

• Maximization of Profit: Directs all efforts toward achieving profit targets.
• Coordination: Achieves coordination among various departments.
• Efficiency: Encourages efficiency by fixing responsibility and setting targets.
• Cost Control: Helps in controlling costs by comparing actual with budgeted.
• Delegation of Authority: Facilitates delegation of authority and responsibility.
• Basis for Policy: Provides a sound basis for framing future policies.
• Introduces Incentive Schemes: Performance can be linked to rewards.
• Economical Use of Resources: Ensures optimum utilization of resources.

Limitations of Budgetary Control:

• Based on Estimates: Accuracy depends on the reliability of forecasts.
• Danger of Rigidity: Budgets may become rigid and hamper flexibility.
• Not a Substitute for Management: It is only a tool; success depends on execution.
• Costly: Installation and operation involve considerable expense.
• Time-consuming: Preparation and revision require considerable time.
• Resistance from Staff: Employees may resist targets and controls.
• Requires Top Management Support: Fails without commitment from senior management.
• Conflict Between Departments: May create friction over resource allocation.

Meaning of Master Budget:

A master budget is a summary budget that consolidates all the functional budgets of an organization into a single comprehensive plan. It is the highest-level budget that presents the overall picture of the planned operations and financial position of the firm.

According to CIMA: "The master budget is the summary budget incorporating its functional budgets, which is finally approved, adopted and employed."

Components of Master Budget:

• Operating Budgets: Sales budget, production budget, material budget, labour budget, overhead budget.
• Budgeted Income Statement: Shows expected profit or loss.
• Financial Budgets: Cash budget and capital expenditure budget.
• Budgeted Balance Sheet: Shows the projected financial position at period end.

Significance of Master Budget:

• Provides a complete overview of the entire organization's plans.
• Serves as a coordinating device among all departments.
• Acts as a benchmark against which overall performance is measured.
• Helps top management in decision-making and policy formulation.
• Presents the projected profitability and financial position of the firm.

Meaning of Key Factor:

The key factor, also called the principal budget factor or limiting factor, is the factor that limits or restricts the activities of an organization at a particular point of time. It is the constraint around which the entire budgeting process is built.

According to CIMA: "The principal budget factor is the factor which, at a particular time or over a period, will limit the activities of an undertaking."

Importance:

• The budget for the key factor must be prepared first, and all other budgets are prepared based on it.
• Ignoring the key factor makes the whole budgeting exercise unrealistic.

Examples of Key Factors:

• Sales: Lack of demand or market competition limits sales.
• Material: Shortage of raw materials.
• Labour: Shortage of skilled labour.
• Plant Capacity: Limited machine hours or production capacity.
• Finance: Shortage of working capital or funds.
• Management: Lack of technical or managerial expertise.
• Government Policy: Restrictions on imports, licences, or quotas.

Example: If a company can sell 10,000 units but its plant capacity allows only 8,000 units, then plant capacity is the key factor, and the production budget must be based on 8,000 units.

Working Note — Collection from Sales:

Since sales are collected fully in the next month:

• January collection = December sales = ₹80,000
• February collection = January sales = ₹1,00,000

Cash Budget (₹)

Note: The closing balance of January (₹25,000) becomes the opening balance of February.

Meaning of Sales Budget:

The sales budget is a forecast of the total expected sales for the budget period, expressed in both quantity (units) and value (₹). It is usually the starting point of the budgeting process because, in most organizations, sales is the key factor.

Factors to be Considered while Preparing Sales Budget:

• Past Sales Trends: Analysis of previous years' sales figures.
• Sales Force Estimates: Reports and forecasts from salesmen.
• Market Conditions: General economic and market conditions.
• Competition: Extent and nature of competition in the market.
• Government Policy: Taxation, import/export restrictions, and other regulations.
• Pricing Policy: Selling price and discount policies of the firm.
• Advertising and Sales Promotion: Planned promotional activities.
• Seasonal Fluctuations: Effect of seasons on demand.
• Product Line Changes: Introduction of new products or discontinuation.
• Availability of Finance and Capacity: Ability to produce and finance the sales.

Significance: The sales budget forms the basis for the production budget, cash budget, and other functional budgets, making its accuracy crucial.

Meaning of Production Budget:

The production budget is a forecast of the total quantity of goods to be produced during the budget period. It is prepared after the sales budget and takes into account the desired levels of opening and closing stock.

Formula for Units to be Produced:

Steps in Preparation:

1. Determine Sales Requirement: Obtain the sales figures from the sales budget.
2. Fix Inventory Levels: Decide the desired opening and closing stock of finished goods.
3. Calculate Production Units: Apply the formula above.
4. Consider Production Capacity: Ensure that the plant can produce the required quantity.
5. Consider the Key Factor: Adjust for any limiting factor (material, labour, capacity).

Example:
If budgeted sales = 10,000 units, desired closing stock = 2,000 units, and opening stock = 1,500 units, then:

Objectives of Production Budget:

• To ensure production meets sales demand.
• To maintain optimum inventory levels.
• To ensure even and efficient use of production facilities.

Both are cost control techniques, but they differ in the following ways:

Relationship: Both techniques are complementary and are often used together for effective cost control.

1. Receipts and Payments Method:

• Under this method, all anticipated cash receipts and cash payments are listed for each period.
• The difference between total receipts and payments (added to the opening balance) gives the closing cash balance.
• Includes: Cash sales, collection from debtors, cash purchases, payment to creditors, wages, expenses, etc.
• Excludes: Non-cash items like depreciation, provisions, and outstanding items.
• Best suited for: Short-term cash forecasting.

2. Adjusted Profit and Loss Method:

• This method starts with the estimated net profit for the period.
• The profit is then adjusted for:
  • Add back: Non-cash expenses (depreciation, provisions, loss on sale of assets).
  • Adjust: Changes in working capital (increase/decrease in debtors, creditors, stock).
  • Deduct: Non-cash incomes and capital expenditure.
• The result gives the estimated cash balance.
• Best suited for: Long-term cash forecasting.

Key Difference:

Working Notes (per unit variable costs at 100%, i.e., 10,000 units):

• Direct Material = ₹4,00,000 / 10,000 = ₹40 per unit
• Direct Labour = ₹2,00,000 / 10,000 = ₹20 per unit
• Variable Overheads = ₹1,00,000 / 10,000 = ₹10 per unit
• Fixed Overheads = ₹1,50,000 (constant total)

Units: 70% = 7,000 units; 90% = 9,000 units.

Flexible Budget (₹)

Conclusion: As capacity utilization increases from 70% to 90%, the cost per unit decreases from ₹91.43 to ₹86.67 due to the spreading of fixed overheads over a larger number of units.

Meaning of Zero-Based Budgeting:

Zero-based budgeting is a method of budgeting in which all expenses must be justified and approved for each new budget period, starting from a "zero base." Unlike traditional budgeting, past figures are not taken as the base; every activity is evaluated afresh as if it is being undertaken for the first time.

Features of ZBB:

• Fresh Start: Every budget begins from zero, ignoring the previous year's figures.
• Justification: Each expenditure must be justified based on cost and benefit.
• Decision Packages: Activities are broken into decision packages that are ranked by priority.
• Cost-Benefit Analysis: Resources are allocated based on the value each activity adds.

Advantages of ZBB:

• Efficient Allocation of Resources: Funds are allocated to activities that are actually needed.
• Eliminates Wasteful Expenditure: Unnecessary or obsolete activities are dropped.
• Focus on Value: Encourages managers to find cost-effective ways of operating.
• Better Decision Making: Priority-based ranking improves resource decisions.
• Improves Communication: Requires detailed evaluation and coordination.

Limitation: It is time-consuming and costly, requiring substantial paperwork and management effort.

Budget Committee:

A budget committee is a group of senior executives responsible for the preparation, coordination, and administration of budgets in an organization.

Functions of the Budget Committee:

• To receive and review functional budgets from various departments.
• To coordinate and reconcile the budgets of different departments.
• To make recommendations and finalize the master budget.
• To review actual performance against budgets and suggest corrective actions.
• To recommend revisions to budgets when necessary.

Composition: Usually headed by the Chief Executive/Managing Director, with the Budget Officer as secretary, and includes heads of major departments (sales, production, finance, purchase).

Budget Manual:

A budget manual is a written document that sets out the responsibilities, procedures, forms, and routines relating to the preparation and use of budgets.

Contents of a Budget Manual:

• Objectives and Scope: Purpose of budgetary control in the organization.
• Responsibilities: Duties of each executive involved.
• Procedures: Methods and timetable for preparing budgets.
• Forms and Reports: Standard formats to be used.
• Account Codes: Classification of accounts for budgeting.

Significance: The budget manual ensures uniformity, clarity, and smooth functioning of the budgetary control system by serving as a standard guide for all involved.