In this article we will discuss about:- 1. Meaning of Budgeting 2. Nature of Budget 3. Process 4. Purposes 5. Essentials 6. Master Budget 7. Flexible Budget 8. Research and Development Budget 9. Capital Expenditure Budget 10. Cash Budget 11. Budgeted Balance Sheet 12. Human Resource Budget 13. Administering the Budget 14. Revision of Budget and Other Details.
- Meaning of Budgeting
- Nature of Budget
- Budgeting Process
- Purposes of Budgeting
- Essentials of Budgeting
- Master Budget
- Flexible Budget
- Research and Development Budget
- Capital Expenditure Budget
- Cash Budget
- Budgeted Balance Sheet
- Human Resource Budget
- Administering the Budget
- Revision of Budget
- Programme Budgeting in Government
- Performance Budgeting
- Zero-Based Budgeting
1. Meaning of Budgeting:
Every firm should articulate its vision. Vision defines the purpose of its existence. E.g., the vision of a health care organization may be to provide health care services affordable to all. Therefore, it continually searches for technology and methods to reduce the cost of health care services, to expand its reach to all segments of the society and to expand geographically. Once the vision is clearly defined, the firm describes its mission. The mission statement clearly describes the activities that it would undertake to achieve its vision.
A clear articulation of vision and mission helps to formulate appropriate strategy. Strategy provides direction to the firm on what to do and how to do to attain the vision in a given environment. Every firm reviews its vision and mission and strategy continuously.
Peter Drucker, while analysing the root cause of why a company that was superstar yesterday finds itself stagnated and frustrated, in trouble and, often, in a seemingly unmanageable crisis writes:
The root cause of nearly every one of these crises is not that things are being done poorly. It is not even that the wrong things are being done. Indeed, in most cases, the right things are being done – but fruitlessly. What accounts for this apparent paradox? The assumptions on which the organisation has been built and is being run no longer fit reality.
These are the assumptions that shape any organisation’s behaviour, dictate its decisions about what to do and what not to do, and define what the organisation considers meaningful results. These assumptions are about markets. They are about identifying customers and competitors, their values and behaviour. They are about technology and its dynamics, about a company’s strength and weaknesses. These assumptions are about what the company gets paid for. They are what I call a company’s theory of business.
The theory of business captures vision, mission, and strategy of a firm. The theory of business is the foundation for planning. In absence of a theory of business and long-term and short-term plans, a firm will be at the mercy of events and will find it impossible to design managerial structure, managerial jobs and to mobilize and allocate resources (people and assets).
Strategies are not purely deliberate. Intended, emergent, and realized strategies may differ from one another. Strategy and other plans should not act as blinders, which obscure the vision about changes occurring in the environment. They should not restrain the entrepreneurship of managers.
Planning begins with choosing objectives or goals, which flows from the theory of business. Successive steps in planning are:
(1) Searching for various alternative ways for achieving the goal,
(2) Evaluating the alternatives, and then
(3) Selecting the most appropriate alternative.
Control is integrated in the planning system.
Control involves comparison of actual results with desired results to provide feedback to managers. Feedback leads to remedial actions or revision of the plan.
The planning and control process is described in Exhibit 13.1.
Budget is a planning and control system. Almost every organization uses budget as a planning and control tool.
We may think about a planning hierarchy. At the top of the hierarchy is the strategic planning and at the bottom is the budgetary control system. Strategic planning has no defined plan period. Strategy defines the theory of business and it may require to be revised with change in the business environment. It provides the parameters for formulating other plans, which may be viewed as the process for strategy implementation.
The next in the hierarchy is the corporate plan, which is a long-term plan. The plan period of a corporate plan is five to seven years. The plan period for budget is usually one year. Budget should mesh with the corporate plan. However, it is wrong to think that the sequence presented in the planning hierarchy is strictly followed.
In fact planning is a learning process. Learning leads to new ideas and consequent modification of strategy and corporate plan. New strategy may emerge during the implementation process. In a rapidly changing business environment, to be effective, the planning system should have in-built flexibility.
Planning does not eliminate uncertainties. They only reduce them. They help managers to shape the future by present actions (Exhibit 13.2).
2. Nature of Budget:
The budget should necessarily be integrated with corporate plan. The budget defines targets in concrete and quantitative terms for the firm as a whole as well as for each functional area. It provides guidelines on how to achieve these targets. It is more administrative and persuasive in nature as compared to the corporate plan and its preparation is the responsibility of line managers.
The budget usually covers a one- year period with a monthly or quarterly break-up. Preparation of such a budget too requires analysis of the present capacity (assets and people) and financial position of the firm and formulation of assumptions about the external environment, such as the state of the economy, the behaviour of the competitors, and the current and prospective demand in the market.
Some organizations follow the ‘continuous (rolling) budget system’. Under this system, at the end of each month or quarter, the month or quarter just ended is dropped and the subsequent month or quarter is added. The greatest advantage of this budget over the periodic budget is that it constantly forces management to think concretely about the forthcoming twelve months.
Under this system, at any point in time, a plan for the next twelve months is available. However, a better system is to prepare the budget for a year, broken down in monthly budgets, and to complement the budget with rolling forecast. Actual results should be compared with both budget targets and the forecast. Investigation into the causes of variances as compared to the budget provides better learning because managers get an insight on where they erred in formulating budget premises.
The budgeting process commences with the establishment of budget objectives. Budget is a tool for the implementation of the corporate plan. Therefore, objectives should flow from the corporate plan. A firm should clearly articulate the objectives for understanding of every employee of the organization. Objectives should be established for the firm as a whole and for each unit. Objectives are usually expressed in concrete terms, such as, percentage of sales growth, ROI, and rate of growth in the market share.
The second step is to formulate budget premises. Formulation of budget requires making assumptions about macroeconomic factors (such as GDP growth rate, inflation, and exchange rates), government policy (such as import and export policy, and policy about external commercial borrowing), regulatory environment (such as telecom licensing for companies in telephony business, and tariff fixation for power generation companies), product market (such as market size and competitors’ strategy), and input market (such as quality, volume and pricing of international logistic services for companies which use significant amount of imported inputs, agricultural productivity across the world for companies which uses agricultural products as inputs).
Managers should also assess the internal environment, such as about the capacity of assets and people, employee morale, and industrial relations.
It is important that these assumptions are articulated explicitly. This helps to analyse the causes of variances, which in turn provides significant learning about the business environment and the strength and weaknesses of the business process adopted by the company as a whole or by a particular SBU.
Once budget premises are established, the next step is to forecast sales in term of quantity and price. Sales forecast is not the sales budget. Sales forecast estimates the product demand taking into account the market size and market share. In other words, sales forecast estimates the maximum sales that the company can achieve during the budget period. Sales forecast leads to identification of the key budget factor, which may limit the activity level and the firm may not be able to service the market demand.
Market demand may itself be a key budget factor. Examples of other key factors are availability of production and distribution capacity, availability of raw material, and regulations restricting the market share. The process of identifying the key budget factor provides insight into the constraints which restrict short-term growth of the firm.
While formulating the budget, managers take into consideration the key budget factor.
Ideally, bottom-up approach should be adopted in formulation of budget. Bottom-up approach helps to involve managers at all levels starting from the lowest decision-making level to the top level in the budgeting process. This earns the commitment of managers who are responsible for implementing the plan. However, in practice, firms seldom adopt the bottom-up approach.
In fact, some agency, external to the firm, sets out the budget objective, and this drives other budget targets. For example, for a listed company, the stock market sets out the objective analysts’ expectations about growth and performance, as articulated in research reports, set the objective.
Sometimes, the growth and return on invested capital (ROIC) projected by the industry leader sets the benchmark objective. In case of a subsidiary of an MNC, the parent company sets the objective. In case of state-owned enterprises, often, the concerned minister sets the objective while replying questions in the parliament.
Managers stretch themselves to achieve the objective set out by the external agency unless it is impossible to achieve the same. They use the budgeting process to evaluate alternative plans and select the optimal plan, which is expected to achieve the desired result. Managers at all levels provide ideas and get involved in the budgeting process. Thus, in practice, firms adopt a combination of the top-down and bottom-up approaches.
The final outcome of the budgeting process is the master budget. It is a comprehensive plan, a co-ordinated set of detailed financial statements and schedules for a short period, usually a year. Schedules take the shape of functional budgets.
The master budget embraces both operating decisions and financing decisions.
Operating decisions are incorporated in the operating budget which covers the following:
(ii) Ending inventory
(iv) Direct materials
(v) Direct labour
(vi) Factory overhead
(vii) Cost of goods sold
(viii) Selling expense
(ix) Administration expense
The operating budget culminates in the budgeted income statement.
The financial budget comprises capital budget, cash budget, budgeted balance sheet, and budgeted statement of changes in the financial position.
Once the broad plan is finalized, budgets for the firms as a whole and for each unit are formulated. Targets for revenue, cost and capital are set out in monetary terms and in some cases in other quantitative terms as well.
Each manager is informed of the key budget factor and the skeleton plan and is provided with broad policy guideline. Each manager prepares subsidiary budgets for her area of responsibility based on the communication received by her. She submits this to her superior who scrutinizes the same to ensure that budgets are formulated within the broad framework and are directed to achieve departmental goals.
The superior manager modifies budgets, if necessary, after discussion with her subordinates. The supervisor must try to get her subordinates agreed to proposed modifications. Each departmental manager consolidates subsidiary budgets submitted by her subordinates and submits the departmental budget to her superior.
She modifies, if necessary, the budgets received from all her subordinates and consolidates the same to prepare the budget for the area for which she is responsible. The process continues till all the functional budgets reach the budget committee for discussion and final compilation of the income statement.
Communication of budget key factors, skeleton plan, and budget policies move ‘top- down’ while subsidiary budgets move ‘bottom-up’.
The process of modification of subsidiary budget submitted by a manager takes the form of negotiation. Ideally, subsidiary budgets prepared by managers responsible to a particular superior are presented before the superior in a formal manner. Some top-level managers also participate in these presentations.
Budgets so presented are critically analysed, modifications are suggested and discussed, and a final decision is taken either to accept the budgets without modification or with agreed modifications. This procedure is adopted at all stages. It ensures participation and acts as a motivational force.
Negotiation of subsidiary budgets ensures that they are compatible with the overall goals and that they are integrated with each other. This process gives a chance to lower level managers to analyse their own functions in a wider perspective. Lower level managers will be much more inclined to adopt the right attitude to budget formulation and control procedures if they are involved and consulted in the subsidiary budget preparation process.
The budget committee discusses all the subsidiary budgets and approves them with or without modifications. The controller consolidates all subsidiary budgets to draw the master budget.
Subsidiary budgets, approved by the board of directors, are sent back to the various units.
A budgetary control system when administered intelligently serves the following purposes:
(a) It compels managers to look ahead and to be ready for the changing conditions.
(b) It compels managers to analyse the environment, forecast changes, set goals, and formulate a plan to achieve the goals. This helps to identify strategic, operational, and financial risks flowing from the strategy and to formulate appropriate risk management strategy.
(c) It provides a criterion for performance evaluation.
(d) It acts as a formal communication of what is expected from each level of employees and lets them know how to achieve the objectives of the firm. This communication of clear, well-defined, quantitative targets and the resources allocated to achieve the same helps managers to achieve the desired performance through a proper co-ordination of goals and means.
(e) Co-ordination implies harmony of individual efforts towards the accomplishment of the firm’s objectives. It involves meshing and a balancing of all factors of production and all departments and functions so that the firm’s objectives can be achieved. It is said that the best co-ordination occurs when individuals see how their efforts contribute to the goals of the firm. The budgeting process provides such visualization.
A well-laid plan brings to the surface the relationships between the goals of each unit and the goals of the firm as a whole. Budget discussions help each individual manager to understand how performance in her functional area affects the performance in other functional areas and the overall performance of the firm as a whole.
This also restrains empire-building efforts by individual managers by removing conscious bias and conflicts. Identification of weaknesses in the organization structure, such as a weak communication system, weaknesses in working relations, and in fixing responsibilities, is another significant contribution of the budgetary control system towards achieving coordination.
Effectiveness of a budgetary control system depends on how much support it receives from the top management. If the top management uses the system for ‘command and control’, the effectiveness of the system is lost. On the other hand if the top management uses the system as a process of learning, the effectiveness of the system increases because of active involvement of managers at all levels. It also encourages managers to use the system effectively.
The budget targets should be stretched targets in the sense that they should not be achievable easily. Only stretched targets bring out the best of managers’ creativity. However, many believe that targets should be realistic because unrealistic targets might adversely affect employee morale.
In order to be effective, the budgetary control system should be synchronized with the organization structure. Targets should be set out for each individual accountable for a specific set of activities.
Flexibility should be in-built in the budget. The system should not restrain a manager from taking a prudent action warranted under a given situation. In a dynamic environment, the success of a firm depends on managers’ problem-solving skills and their ability to respond to challenges and opportunities that could not be visualized during the planning process.
Sales forecast forms the basis of the sales budget. Usually sales forecast is prepared on the basis of the field level data and secondary data available in research reports issues by industry associations and agencies involved in macroeconomic research. Firms, which operate in FMCG industry or consumers’ durable industry or in any other similar industry use statistical tools, such as trend analysis, cycle projection, and correlation analysis, to forecast sales.
Sales budget incorporates management decisions on the following:
(a) Market Positioning:
Management has to decide the marketing strategy for each geographical area, and the firm’s positioning vis-a-vis its competitors.
(b) New Products:
New products are usually introduced in a phased manner.
Export plan should be drawn separately.
Sales budget should set out the optimal product mix. Marginal costing technique may be used to determine the optimal product mix. The target is expressed in both qualitative terms and in terms of value. It should clearly bring out sales targets for each product and for each geographical area. It is essential that before the finalization of the sales budget, the production capacity should be reviewed. Sales budget should be synchronized with the production budget.
A comparison of forecasted sales with the manufacturing capacity helps to draw the long-term plan for capacity expansion.
Production budget should be synchronized with the sales budget. A production budget is stated in physical units and it matches with the sales budget adjusted for proposed accretion or decretion to finished goods level.
The process of formulation of the production budget commences with the assessment of the production capacity. Production capacity depends on the asset capacity and the capacity of people in terms of skills. Usually, the corporate plan should provide for augmenting both asset capacity and people capacity because it is difficult and often impossible to augment capacity through short-term measures.
Short-term measures marginally increase the available capacity. E.g., overtime working, reduction in absenteeism, improvement in productivity, and outsourcing of certain activities increase the capacity marginally. In estimating the production capacity, one should take into consideration outcome of ongoing capital expenditure projects, plans for installation of balancing facilities to remove bottlenecks in the production process, and improvement in capacity through replacement of old equipment.
The available standard hours should be determined for each workstation. It helps to locate imbalances between the capacities available at different workstations. Further, it brings to focus the short-fall in standard hours required to meet the sales budget.
Integration of the production budget with the sales budget is of extreme importance. Frequently management prefers even production despite seasonal fluctuations in sales. The other alternative is to adjust production for seasonal fluctuation in sales to maintain uniform inventory level. The advantage of the first is stable utilization of personnel and facilities while the other results in a lower inventory carrying cost.
The production budget determines the direct material usage budget. Quantities are translated into value by using estimated prices for each type of material. Estimated prices are determined with reference to the estimated stock in hand at the beginning of the budget period, and the contracts already entered into with suppliers and probable movements in prices.
The purchase of direct material depends on both budget usage and inventory levels.
Besides, two other important factors which influence purchase budget are the following:
(a) Economic order quantity
(b) Reorder point with safety stock to cover fluctuations in demand.
Establishment of direct materials purchase budget helps the purchaser to draw a purchasing schedule and also to enter into long-term contracts wherever possible. This also helps to plan for the financial requirements of the purchasing department which, in turn, helps to draw the cash budget.
Usually, materials purchase budget covers purchase of direct materials, indirect materials, purchased services, and similar items.
Direct labour budget must tie in with the standard hours of production as laid down in the production budget.
The following factors should also be considered:
(i) Trend in the productivity
(ii) The probable effects of methods improvement
(iii) The probable effects of changes in the design of the product
Direct labour budget shows the number of workers required in different grades. These numbers are translated into value using estimated wage rate for each category of workers.
Direct labour budget helps personnel department to draw recruitment and training programmes. It facilitates the preparation of the cost of sales budget and the cash budget.
Indirect labour cost budget is established with reference to the production budget and direct labour budget. Indirect labour budget estimates the number of indirect workers required translated in rupee value.
Factory overhead budget is prepared with reference to the chart of accounts. Expenses under various account heads (with natural classification, such as indirect materials and supplies, freight, light, power, and so on) are estimated. This requires classification of expenses according to variability, i.e., fixed, semi-fixed, and variable.
Total expenses under various account heads are allocated to various cost centres. The budget classifies total expenses of a cost centre into controllable expenses and uncontrollable expenses. Controllable expenses are those that are controllable by decisions and actions of the manager in charge of the cost centre. The manager is accountable for controllable expenses.
The cost centre manager submits her estimates of expenses based on the projected activity level of her cost centre. These estimates are reviewed and discussed before incorporation in the overall budget. The approved budget forms the basis of reporting variances.
This budget shows the desired level of closing stock of raw materials, work-in-progress and finished goods. This is required to prepare production budget, material purchase budget, budgeted income statement, and budgeted balance sheet. Ending inventory budget conforms to norms established by the firm.
Moreover, firms benchmark their inventory management with the best in the industry. They use budget as an instrument for improving inventory management. The budget sets targets for reducing inventory levels of different types of inventory items.
The chief of the sales function is usually responsible for the preparation of the selling and distributions cost budget.
Selling and distribution cost can be divided into the following:
(a) Direct selling expenses
(b) Distribution expenses
(c) Establishment expenses of various sales offices
(d) Expenses on publicity and advertisement
Classification of expense into fixed, semi-variable, and variable is extremely important for correct estimation of the selling and distribution cost.
Expenses on publicity and advertisement are discretionary in nature. There is no cause and effect relationship between these expenses and sales volumes. However, the launching of a new product, re-entry into a lost market, publicity of new attributes feature in an old product, etc., definitely influence the publicity and advertisement expenses. Budget takes all these factors into consideration.
Administration costs are mostly fixed in nature, some of which are committed while others are discretionary. Management may decide to increase expenses on security, strengthen internal audit department, increase accounts staff to cope with increase in work, strengthen public relations department, and to introduce office automation. Administration cost budget takes into consideration all such decisions and indicates a detailed break-up of the total administration costs.
A flexible budget recognizes the difference between the behaviour of fixed and variable costs in relation to fluctuations in output, turnover, or other variable factors such as number of employees. In flexible budget, target per unit of the cost driver is established to make the variance reporting meaningful. E.g., target for variable manufacturing overhead may be established as ‘allowed expenses per hour’. Similarly, target for direct material cost may be established as cost per unit of output.
Usually a flexible budget discloses the budget formula, which is used to calculate revenues and costs expected at any level of the activity in the relevant range. Alternatively, in a flexible budgeting system, budgets for different activity levels are prepared. E.g., budgets for performance at 70%, 80%, 90%, and 100% of target production/sales levels are prepared. If the actual production/ sale is at 90% of the target, actual revenue and expenses are compared with those established for the budget at 90% level.
8. Research and Development Budget:
The unique features of research and development activities are the following:
(a) It is difficult to measure the profitability of research and development expenditure.
(b) Research and development activities are future oriented and, therefore, do not bring immediate results.
(c) Research and development activities are non-standard, non-repetitive and the results of those activities are uncertain.
In view of these unique features, cost-benefit analysis cannot be carried out at the point of allocation of resources to a particular research or development project. However, to ensure optimum utilization of resources, funds should be allocated only to specific well-defined projects and only after initial assessment of benefits that would accrue to the firm on successful completion of those projects.
Research and development budget is in the nature of appropriation budget. The total amount to be appropriated to research and development activities is often fixed as a percentage of sales or as a percentage of profit.
The total amount so appropriated is divided among the following:
(a) Contribution to research institutes.
(b) Allotment to continuing projects. This requires review and a correct assessment of the progress of each project and its chances of success.
(c) Allotment to new projects. Each research project should have well defined objectives and a project report should be prepared to show the probable chances of success, likely benefits to accrue and the tentative period of completion. Each development project must have a time-bound programme for completion.
Capital expenditure budget is the plan for the acquisition of fixed assets.
Capital expenditure budget should be segregated into the following:
(a) Expenditure on Balancing Facilities:
Balancing facilities refer to those facilities which are required to be installed to remove bottlenecks in the production process.
(b) Expenditure on Replacement of Existing Facilities:
Replacement of existing facilities is a continuous process. Firms continuously review the condition of old assets which have already lived their useful life estimated at the time of installation, and replace some of those assets every year to avoid creation of a production bottleneck and also to avoid heavy commitment in a particular year. Sometimes, replacement decisions are taken to improve productivity.
(c) Expenditure on Continuing Projects:
New projects under an expansion plan or those under diversification plan usually take more than one year for completion. Allocation of resources to those plans is made according to the approved programme so that a project is not delayed due to non-availability of resources.
Delayed completion of a project results in cost overrun and loss of benefits (e.g. incremental profit) considered while evaluating the viability of the project. Normally these projects involve huge capital outlay and, therefore, delay in completing, affects the overall economic performance of the firm significantly.
(d) Expenditure on Non-Profit Projects:
These are projects undertaken to meet legal (e.g. pollution control) or safety requirements.
The budget should establish milestones and target dates for achieving these milestones.
Capital expenditure has a long-term influence on the operation of a firm and once a fixed asset is acquired, it is very difficult, if not impossible, to retrieve the amount already invested in the asset. Therefore, before inclusion of a capital expenditure proposal, it should be carefully evaluated as to its viability.
Normally every company sets out a detailed guideline for capital expenditure approval. Inclusion of a capital expenditure proposal in the budget usually requires the prior approval of top management.
However, top management often delegates authority to approve capital expenditure to functional heads subject to certain conditions such as the expenditure up to certain amount may be approved by functional managers if the project return is higher than the hurdle rate established by the top management.
In most firms a top level committee screens proposals received from managers before forwarding the same to the board of directors for final approval. Plans for capital expenditure, under a diversification plan or expansion plan form a part of the ‘corporate plan’ which bears the approval of the board of directors.
A cash budget is a statement of planned cash receipts and disbursements. It is based on the level of operation planned for the budget period and the capital expenditure budget. Cash budget should be prepared for each month covered in the budget period. Cash budget helps to avoid unnecessary idle cash and also unnecessary cash deficiencies.
The following principles should be borne in mind:
(i) Cash receipts include collection from customers (for credit sales), cash sales, non- operating income, (e.g. dividend, interest on securities), and other operating income (rent received, sale of assets).
Collection from customers should be estimated on the basis of the forecasted credit sales and credit policy for various categories of customers. There is always a time lag between the credit sales and collection from customers.
Although, ideally credit period in excess of credit allowable as per management policy should not be granted, the collection experience may show that the average time lag between credit sales and collection from customers is more than the credit period allowed under sales contracts. Actual collection experience must be considered for correct forecasting of cash receipts.
(ii) Payment to trade creditors depends on the credit terms with suppliers of goods and services. However, if past experience shows that actual credits allowed by suppliers were more than the agreed terms, the same should be taken into consideration in estimating disbursements to trade creditors.
As the credits allowed by various suppliers are not uniform, it is necessary to plan when and how much of the total quantity as per material purchase budget will be purchased from different suppliers, so that disbursements on account of payment to suppliers can be forecasted correctly.
(iii) Payment to employees depends upon payroll dates.
(iv) Other operating costs and expenses depend upon the timing and credit terms. Timing of actual cash disbursements should be considered. Depreciation and other non-cash expenses should not appear in the cash budget.
(v) Disbursement against capital expenditure depends upon the capital expenditure budget. It requires correct forecasting of timings for ordering of assets and corresponding timings for releasing advances and final payments.
(vi) Disbursements should also include the payment of dividend, instalment payments for purchases, etc.
(vii) Minimum cash balance desired depends upon the nature of the business and conditions in the money market.
The final step is the preparation of the budgeted balance sheet. Each item of assets and liabilities is projected to reflect business plan as expressed in operating budget, capital expenditure budget, and cash budget. The opening balances of assets and liabilities are adjusted for cash receipts and cash disbursements, credit sales and credit purchases, accrued expenses and accrued income, prepaid expenses and other non-cash expense items appearing on the budgeted income statement.
It is essential that the human resource budget should be meshed with human resource plan incorporated in the corporate plan. Human resource planning is the process of analysing and estimating the need for and availability of skills.
Human resource planning takes into consideration various factors which include the following:
(i) The current inventory of skills
(ii) Normal attrition due to retirement or death
(iii) Estimated turnover of employees
(iv) Required skills to meet planned targets
Human resource planning includes assessment of training needs and planning training programmes. It is the responsibility of the human resource department to draw the human resource budget in co-ordination with other functional departments. However, accounts department renders assistance in calculating salaries and wages.
13. Administering the Budget:
Usually the financial controller acts as the budget co-ordinator. She provides the necessary help and guidance to line mangers. She is responsible for co-ordinating the budget preparation. Moreover, the overall responsibility for the effective functioning of the budgetary control system lies on the budget co-ordinator.
She has the following additional responsibilities:
(i) Establishment of preparatory procedures
(ii) Designing the forms
(iii) Collecting and co-ordinating data
(iv) Verifying information
(v) Reporting variances between actual performance and budget performance
For effective functioning, the budget co-ordinator must command the respect, confidence, and co-operation from all the members of the organization.
A budget committee is a consultative body to the budget co-ordinator. Members include the budget co-ordinator and functional heads. Usually the budget co-ordinator acts as the secretary to the committee.
Although the budget committee is an advisory body, it has specific responsibilities such as the following:
(i) To assemble, review, and transmit underlying economic conditions and other budget premises.
(ii) To review and co-ordinate departmental budgets.
(iii) To scrutinize variance reports and to submit recommendations to top management.
(iv) To help managers to develop operating and financial plans, to reconcile divergent views, and to co-ordinate budget activities.
A budget manual is a document that describes the organization set up, budget policies, routine programmes and procedure to be followed for developing budgets. It also describes designations and responsibilities of various authorities involved in preparing and administering the budgetary control system.
The budget manual serves as a rule book.
Investigation of variances is the responsibility of line managers. The Budget co-ordinator has the responsibility to ensure that variance reports are issued as per schedule and corrective actions on budgetary variations are taken without loss of time. Follow-up is important for the effective functioning of the budgetary control system. The budget committee reviews the ‘Action Taken Report’ periodically and submits the same to the top management.
14. Revision of Budget:
For effective control, actual results are monitored period by period and for this purpose yearly budget is broken down into monthly budgets. If comparison of actual results period by period reflects adverse variances, the question arises whether budgets for the balance period of the year should be revised.
The argument in favour of revision of the original budget is that such a revision would take into account the intervening changes in the business situation and future comparison of actual results with revised budget would be more meaningful. The argument against the revision of the budget is that the revision of the budget reduces the effectiveness of the budgetary control system.
Usually, if budget premises are established with care, no significant change should occur in the business environment during the budget period. Revision of the budget conceals weaknesses in establishing budget premises. Whether the original budget is to be revised should be decided after scrutinizing the causes of variances.
Programme budgeting is used in connection with planning, programming, and budgeting. The objective is to make government operations more efficient and effective. Efficiency is measured by the output-input ratio. Effectiveness refers to the attainment of a predetermined goal. Programme budgeting was introduced in the US Department of Defense in 1961. Subsequently it was extended to other departments. It aims at optimum utilization of available scarce resources.
Programme budget covers a reasonably long period (say 5-10 years) so as to cover the life of a programme. The budget is classified in terms of programmes and not in terms of functions or the process of functioning.
Functions represent the broad classifications of operations necessary to achieve well-defined goals. Programmes are broad sub-divisions of a function. Activities represent segments (which represent a group of homogeneous work) of a programme. E.g., agriculture is a government function; high-yielding variety is a programme and ‘construction of warehouses’ is an activity.
Programme budgeting has an orientation towards achieving social objectives. The emphasis lies on the cost-benefit analysis of each sub-programme so that the most favourable sub-programme can be selected out of alternative competing sub-programmes.
The process of programme budgeting can be summarized as below:
(a) Define goals to be achieved (e.g. alleviation of poverty).
(b) Define the functions necessary to achieve the goals (e.g. improvement in the production and productivity of wage goods).
(c) Develop alternative programmes, which would help in the attainment of goals (e.g. mechanization of agriculture, land reform, provision for irrigation facilities, and provision for fertilizer). Programmes should be defined in terms of output, costs, and benefits so that each programme can be evaluated in terms of cost-benefit analysis.
(d) Select the programme, which is most favourable in terms of net benefit (i.e. output and related costs) so that the available funds can be allotted to the most beneficial programme. The final choice of programme ensures optimum utilization of resources and attainment of pre-defined goals.
It must be appreciated that the evaluation of a programme necessitates its segregation into activities/projects so that the costs and output can be estimated correctly. Programme budgeting is concerned with planning and, therefore, is most relevant to top-management problems.
Performance budgeting aims to evaluate performance at various cost centres. The budget is classified in terms of functions. The orientation is towards developing work programmes and the performance criterion necessary for attainment of goals of the enterprise and for measuring the performance at various levels. The focus is on control through performance measurement.
Programme budgeting addresses itself to the selection of a programme and is concerned with planning, while performance budgeting addresses itself to the measurement of operational efficiencies and effectiveness. Therefore while programme budgeting is considered relevant to the top-management function, performance budgeting is relevant to functions at lower and middle management levels.
In conventional budgeting targets are fixed in terms of money, while in performance budgeting targets are fixed both in terms of physical units and money. Thus, performance budgeting is an improvement over the conventional budgeting system.
The process of performance budgeting is summarized below:
(a) Establishment of well-defined responsibility centres.
(b) Establishment of targets in terms of physical units for each responsibility centre so that actual performance can be measured against the same.
(c) Forecasting costs and revenues against physical targets already established.
(d) Evaluation of actual performances by comparing results with both physical targets and monitory targets. Variance reports show these variances separately.
Following are the examples of physical targets- For each production centre targets can be fixed in terms of the standard hours to be produced; for each sales-territory targets can be established in terms of the units of products to be sold. Similarly, in capital expenditure budget targets may be established in terms of the expected physical progress (termed as milestones) to be achieved.
The basic philosophy of performance budgeting is not different from that of conventional budgeting. Government departments and public sector enterprises extensively use performance budgeting.
Zero-based budgeting (ZBB) is a method of budgeting whereby all activities are re-evaluated each time a budget is formulated. Each functional budget starts with the assumption that the function does not exist and is at zero cost. Increments of cost are compared with increments of benefits culminating in the planned maximum benefit given the budgeted cost.
Conventional budgeting can be viewed as ‘incremental budgeting’ in the sense that it takes the latest estimate of the previous period’s results as bases to establish budget targets. Previous year’s estimated results are adjusted based on experience during the previous period and expectations for the budget period. E.g., if 10% growth in revenue is planned, costs would be estimated accordingly; the exact increase would depend upon the behaviour pattern of each item of costs.
While incremental budgeting asks such questions as ‘how much’, ZBB asks such questions as ‘why’. ZBB does not consider the previous period’s budget and actual results as bases for future planning. It critically reviews and questions justification for the previous year’s activities and spending and in a way starts planning from ‘zero base’.
ZBB evaluates both current and new activities and endeavours to find answers to such questions as:
(a) How justified are the current activities?
(b) How efficient and effective are the current operations?
(c) Should current operations be reduced in order to fund higher priority new programmes?
Under ZBB each manager has to document the following major steps:
(a) Determine objectives, operations, and the costs of all current and new activities under her control.
(b) Search for alternative means of conducting each activity.
(c) Evaluate various alternative means in terms of costs and benefits at various levels of efforts for each activity.
(d) Establish evaluation criterion for measuring work load and performance.
(e) Rank all the activities including the proposed new activities in terms of preference.
The process of ZBB is summarized below:
(a) Decision units are lowest levels of an organization, the activities of which can be reviewed and analysed separately and to which cost/revenues can be assigned. A separate budget is prepared for each decision unit.
(b) A set of decision packages is prepared for each decision unit. A decision package documents various levels of activities that may be carried out by the decision unit.
It contains key information such as:
(i) Specification of the objectives of the decision unit.
(ii) Consequence of not carrying out activities.
(iii) Alternative means of accomplishing objectives.
(iv) Financial implications of various levels of operations.
(v) Decision package developed for each decision unit are ranked in order of preference.
(vi) Decision packages (with appropriate ranking) developed by decision units are forwarded to the next higher level of management. The manager at the next higher level prepares a consolidated ranking of all the decision packages received by her and forwards the same to her superior. The process continues till all the decision packages reach the highest reviewing level of the budget committee.
(vii) Finally, decisions are taken to approve or disapprove each of the decision packages and to allocate resources to each approved decision package.
As regards spending budget, ZBB is more relevant for discretionary costs rather than engineered costs.
The following are the advantages of ZBB:
(a) It compels a continuous review of objectives of each decision unit.
(b) Managers of each decision unit get actively involved in the budgeting process and are forced to develop alternative means for accomplishing objectives.
(c) Out of date and inefficient operations are identified.
(d) Current activities and proposed new activities get equal importance.
(e) Priorities among activities are better pinpointed.
(f) Resources are allocated according to needs and benefits.
The time and the cost of preparing ZBB are much higher than the same for formulating conventional budget. Therefore, firms conduct zero base review for each department in rotation along with the conventional budgetary control system rather than conducting ZBB for all departments annually.
Implementation of ZBB requires proper training to managers to enable them to define objectives, develop decision package, and to evaluate alternative means for accomplishment of objectives.