Unit – 3: Budget and Budgetary Control

Meaning and Definition of Budget, Budgeting and Budgetary Control:

Budget: A budget is the monetary and / or quantitative expression of business
plans and policies to be pursued in the future period of time. Budgeting is
preparing budgets and other procedures for planning, coordination and control
or business enterprises.
I.C.M.A. defines a budget as “A financial and / or quantitative 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”.
Budgeting refers to the process of preparing the budgets. It involves a detailed
study of business environment clearly grasping the management objectives, the
available resources of the enterprise and capacity of the enterprise.
Budgeting is defined by J.Batty as under: “The entire process of preparing the
budgets is known as budgeting”.
Thus budgeting is a process of making the budget plans. Preparation of budgets
or budgeting is a planning function and their implementation is a control
function. ‘Budgetary control’ starts with budgeting and ends with control.
Budgetary control is the process of preparation of budgets for various activities
and comparing the budgeted figures for arriving at deviations if any, which are
to be eliminated in future. Thus budget is a means and budgetary control is the
end result. Budgetary control is a continuous process which helps in planning
and coordination. It also provides a method of control.
According to Brown and Howard “Budgetary control is a system of
coordinating costs which includes the preparation of budgets, coordinating the
work of departments and establishing responsibilities, comparing the actual
performance with the budgeted and acting upon results to achieve maximum
profitability”.
Wheldon characterizes budgetary control as planning in advance of the
various functions of a business so that the business as a whole is controlled.
I.C.M.A. define budgetary control as “the establishment of budgets, relating
the responsibilities of executives to the requirements of a policy, and the
continuous comparison of actual with budgeted results either to secure by
individual actions the objectives of that policy or to provide a basis for its
revision”.
Features of Budgetary Control:
A budgetary control system can be defined as the establishment of budgets
relating to the responsibilities of executives to the requirements of a policy, and
the continuous comparison of actual with budgeted results either to secure by
individual action the objective of that policy or to provide a base for its revision.
The salient features of such a system are the following:
(a) Objectives: Determining the objectives to be achieved, over the budget
period, and the policy or policies that might be adopted for the achievement of
these ends.
(b) Activities: Determining the variety of activities that should be undertaken
for the achievement of the objectives.
(c) Plans: Drawing up a plan or a scheme of operation in respect of each class
of activity in physical as well as monetary terms for the full budget period and its
part.
(d) Performance evaluation: Laying out a system of comparison of actual
performance by each person, section or department with the relevant budget arid
determination of causes for the discrepancies, if any.
(e) Control Action: Ensuring that corrective action will be taken where the
plan is not being achieved and, if that is not possible, for the revision of the
plan.
Objectives of Budgetary Control:
The following are the objectives of a budgetary control system:
a) Planning: A budget provides a detailed plan of action for a business over
definite period of time. Detailed plans relating to production, sales, raw material
requirements, labour needs, advertising and sales promotion performance,
research and development activities, capital additions etc., are drawn up. By
planning many problems are anticipated long before they arise and solutions can
be sought through careful study. Thus most business emergencies can be avoided
by planning. In brief, budgeting forces the management to think ahead, to
anticipate and prepare for the anticipated conditions.
b) Co-ordination: Budgeting aids managers in co-coordinating their efforts so
that objectives of the organisation as a whole harmonise with the objectives of
its divisions. Effective planning and organisation contributes a lot in achieving
coordination. There should be coordination in the budgets of various
departments. For example, the budget of sales should be in coordination with
the budget of production. Similarly, production budget should be prepared in co-
ordination with the purchase budget, and so on.
c) Communication: A budget is a communication device. The approved budget
copies are distributed to all management personnel who provide not only
adequate understanding and knowledge of the programmes and policies to be
followed but also gives knowledge about the restrictions to be adhered to. It is
not the budget itself that facilitates communication, but the vital information is
communicated in the act of preparing budgets and participation of all responsible
individuals in this act.
d) Motivation: A budget is a useful device for motivating managers to perform
in line with the company objectives. If individuals have actively participated in
the preparation of budgets, it act as a strong motivating force to achieve the
targets.
e) Control: Control is necessary to ensure that plans and objectives as laid down
in the budgets are being achieved. Control, as applied to budgeting, is a
systematized effort to keep the management informed of whether planned
performance is being achieved or not. For this purpose, a comparison is made
between plans and actual performance. The difference between the two is
reported to the management for taking corrective action.
f) Performance Evaluation: A budget provides a useful means of informing
managers how well they are performing in meeting targets they have previously
helped to set. In many companies, there is a practice of rewarding employees on
the basis of their achieving the budget targets or promotion of a manager may be
linked to his budget achievement record.
Advantages of Budgetary Control:
A budget is a blue print of a plan expressed in quantitative terms. Budgeting is
technique for formulating budgets. Budgetary Control, on the other hand, refers
to the principles, procedures and practices of achieving given objectives through
budgets.

Here are the some Advantages of Budgetary Control:

a) Maximization of Profit: The budgetary control aims at the maximization of
profits of the enterprise. To achieve this aim, a proper planning and co- ordination
of different functions is undertaken. There is proper control over various capital
and revenue expenditures. The resources are put to the best possible use.
b) Efficiency: It enables the management to conduct its business activities in an
efficient manner. Effective utilization of scarce resources, i.e. men, material,
machinery, methods and money - is made possible.
c) Specific Aims: The plans, policies and goals are decided by the top
management. All efforts are put together to reach the common goal of the
organization. Every department is given a target to be achieved. The efforts are
directed towards achieving come specific aims. If there is no definite aim then
the efforts will be wasted in pursuing different aims.
d) Performance evaluation: It provides a yardstick for measuring and
evaluating the performance of individuals and their departments.
e) Economy: The planning of expenditure will be systematic and there will be
economy in spending. The finances will be put to optimum use. The benefits
derived for the concern will ultimately extend to industry and then to national
economy. The national resources will be used economically and wastage will be
eliminated.
f) Standard Costing and Variance analysis: It creates suitable conditions for
the implementation of standard costing system in a business organization. It
reveals the deviations to management from the budgeted figures after making a
comparison with actual figures.
g) Corrective Action: The management will be able to take corrective
measures whenever there is a discrepancy in performance. The deviations will
be regularly reported so that necessary action is taken at the earliest. In the
absence of a budgetary control system the deviation can determined only at the
end of the financial period.
h) Consciousness: It creates budget consciousness among the employees. By
fixing targets for the employees, they are made conscious of their responsibility.
Everybody knows what he is expected to do and he continues with his work
uninterrupted.
i) Reduces Costs: In the present day competitive world budgetary control has a
significant role to play. Every businessman tries to reduce the cost of production
for increasing sales. He tries to have those combinations of products where
profitability is more.
j) Policy formulation: It helps in the review of current trends and framing of
future policies.
Limitations of Budgetary Control System:
The list of advantages given above is impressive, but a budget is not a cure all
for organisational ills. Budgetary control system suffers from certain limitations
and those using the system should be fully aware of them.
a) The budget plan is based on estimates: Budgets are based on forecasting
cannot be an exact science. Absolute accuracy, therefore, is not possible in
forecasting and budgeting. The strength or weakness of the budgetary control
system depends to a large extent, on the accuracy with which estimates are made.
Thus, while using the system, the fact that budget is based on estimates must be
kept in view.
b) Danger of rigidity: Budgets are considered as rigid document. Too much
emphasis on budgets may affect day-to-day operations and ignores the dynamic
state of organization functioning.
c) Budgeting is only a tool of management: Budgeting cannot take the place
of management but is only a tool of management. ‘The budget should be regarded
not as a master, but as a servant.’ Sometimes it is believed that introduction of a
budget programme alone is sufficient to ensure its success. Execution of a budget
will not occur automatically. It is necessary that the entire organisation must
participate enthusiastically in the programme for the realisation of the budgetary
goals.
d) False Sense of Security: Mere budgeting cannot lead to profitability.
Budgets cannot be executed automatically. It may create a false sense of security
that everything has been taken care of in the budgets.
e) Lack of coordination: Staff co-operation is usually not available during
budgetary control exercise.
f) Expensive Technique: The installation and operation of a budgetary control
system is a costly affair as it requires the employment of specialized staff and
involves other expenditure which small concerns may find difficult to incur.
However, it is essential that the cost of introducing and operating a budgetary
control system should not exceed the benefits derived there from.
 Zero Based Budgeting
ZBB is defined as ‘a method of budgeting which requires each cost element to
be specifically justified, as though the activities to which the budget relates were
being undertaken for the first time. Without approval, the budget allowance is
zero’.
Zero – base budgeting is so called because it requires each budget to be prepared
and justified from zero, instead of simple using last year’s budget as a base. In
Zero Based budgeting no reference is made to previous level expenditure. Zero
based budgeting is completely indifferent to whether total budget is increasing
or decreasing.
‘Zero base budgeting’ was originally developed by Peter A. Pyher at Texas
Instruments. Peter A. Pyher has defined ZBB as “an operating, planning and
budgeting process which requires each manager to justify his entire budget
request in detail from scratch (hence zero base) and shifts the burden of proof to
each manager to justify why we should spend any money at all”.
CIMA has defined it “as a method of budgeting whereby all activities are
revaluated each time a budget is set."
Benefits and Limitations of Zero Base Budgeting
The major benefits of the use of zero base budgeting can be the following:
a) Zero base budgeting examines all existing and new programmes and
activities. It also makes the managers analyse their functions, establish priorities
and rank them. This exercise helps in identifying inefficient or obsolete functions
within the area of responsibility. In this way resources are allocated from low
priority programmes to high priority programmes.
b) This system facilitates identification of duplication of efforts among
organisational units. Such inefficient activities are eliminated and some other
activities are merged.
c) All expenditures, under this system are critically reviewed and justified and
all operations activities are evaluated in greater detail in terms of their cost-
effectiveness and cost-benefits. This requires managers to find alternative ways
of performing their activities which may result in more efficient procedures.
d) ZBB promotes the tendency to initiate studies and improvements during the
period of operation as the persons at the helm of affairs know that the process
would be exercised next year and their knowledge and training would enhance
efficiency and cost-effectiveness.
e) ZBB provides for quick budget adjustments during the year. If revenue falls
short in this process, it offers the capability to quickly and rationally modify
goals and expectations to correspond to a realistic and affordable plan of
operations.
f) ZBB ensures greater participation of personnel in formulation and ranking
processes. This helps in promoting level of job satisfaction and thus resulting in
better control and operational efficiency in the organisation.
g) Zero base budgeting is a flexible tool that can be applied on a selective basis.
It does not have to be applied throughout the entire organisation or even in all
the service departments. Keeping in view the limitations of
time, money and persons available to install, operate and monitor it the
management thus can select priority areas to which zero base budgeting may be
applied.
Limitations of ZBB can be summed up as:
a) It challenges the past practices, performance, attitudes, of people.
b) It requires more time and effort.
c) Detailed costs and necessary information for decision packages often are not
made available.
d) It increases paper work to unmanageable proportions.
e) Ranking a large number of decision packages becomes an unwieldy process.
f) Identifying various levels of funding, particularly the minimum level is a
difficult task.
Steps in Zero-Base Budgeting
a) Determination of Objectives: The first step in ZBB is the clear definition of
the objectives of budgeting. The objective may be to reduce expenditure on staff,
to discontinue an activity or project in preference to another etc.
b) Determination of the Extent of Application: Whether ZBB should be
introduced in all operational areas or only in some selected areas is to be decided.
c) Identification of Decision Units: Decision unit refers to a department, a
project or a product line to which ZBB is to be applied. Identification of such
units is done in consultation with managers.
d) Cost-Benefit Analysis: Cost benefit analysis is undertaken for each activity
of the decision unit. It provides answers to the following questions.
1. Is it necessary to perform the activity at all? If the answer is in the negative,
there is no need for proceeding further.
2. How much is the actual cost and what is the actual benefit of the activity?
3. What is the estimated cost and estimated benefit of the activity?
4. If the unit is dropped, can the unit be replaced by outside agency?
e) Preparation of budgets: The activities and projects for which benefit is more
than the cost are ranked. Priority is accorded to the most profitable
projects/activities, in the allocation of funds.

1. Fixed budget: A fixed budget, on the other hand is a budget which is designed
to remain unchanged irrespective of the level of activity actually attained. In a
fixed budgetary control, budgets are prepared for one level of activity whereas in
a flexibility budgetary control system, a series of budgets are prepared one for
each level of alternative production levels or volumes. According to ICWA
London ‘Fixed budget is a budget which is designed to remain unchanged
irrespective of the level of activity actually attained.”
Fixed budget is usually prepared before the beginning of the financial year. This
type of budget is not going to highlight the cost variance due to the difference in
the levels of activity. Fixed budgets are suitable under static conditions.
2. Flexible budget: A flexible budget is defined as “a budget which, by
recognizing the difference between fixed, semi-variable and variable cost is
designed to change in relation to the level of activity attained”. Flexible budgets
represent the amount of expense that is reasonably necessary to achieve each
level of output specified. In other words, the allowances given under flexibility
budgetary control system serve as standards of what costs should be at each level
of output.
According to ICMA, England defined Flexible Budget is a budget which is
designed to change in accordance with the level of activity actually attained.”
According to the principles that guide the preparation of the flexible budget a
series of fixed budgets are drawn for different levels of activity. A flexible
budget often shows the budgeted expenses against each item of cost
corresponding to the different levels of activity. This budget has come into use
for solving the problems caused by the application of the fixed budget.
Advantages of flexible budget
1. In flexible budget, all possible volume of output or level of activity can be
covered.
2. Overhead costs are analysed into fixed variable and semi-variable costs.
3. Expenditure can be forecasted at different levels of activity.
4. It facilitates at all times related factor can be compared, which essential for
intelligent decision are making.
5. A flexible budget can be prepared with standard costing or without standard
costing depending upon what the company opts for.
6. A flexible budget facilitates ascertainment of costs at different levels of
activity, price fixation, placing tenders and quotations.
7. It helps in assessing the performance of all departmental heads as the same
can be judged by terms of the level of activity attained by the business.
Method of preparing flexible budget
The following methods are used in preparing a flexible budget:
1. Multi-activity method
2. Ratio method
3. Charting method.
1. Multi-Activity method: This method involves preparing a budget in
response to different level of activity. The different level of activity or capacity
levels are shown in Horizontal columns, and the budgeted figures against such
levels are placed in the Vertical Columns. The expenses involved in production
as per budget are grouped as fixed, variable and semi variable.
2. Ratio method: According to this method, the budget is prepared first
showing the expected normal level of activity and the estimated variable cost per
unit at the side expected level of activity in addition to the fixed cost as estimated.
Therefore, the expenses as per budget, allowed for a particular level of activity
attained, will be calculated on the basis of the following formula: Budgeted fixed
cost + (Variable cost per unit of activity × Actual unit of activity).
3. Charting method: Under this method total expenses required for any level of
activity, are estimated having classified into three categories, viz., variable, semi
variable and fixed. These figures are plotted on a graph. The expenses are plotted
on the Y-axis and the level of activity is plotted on X-axis. The graphs will thus,
help in ascertaining the quantum of budgeted expenses corresponding to the level
of activity attained with the help of this chart.
Difference between Fixed Budget and Flexible Budget
 Fixed Budget Flexible Budget
1. It does not change with actual volume It can be recasted on the basis
of activity achieved. Thus it is known as of activity level to be achieved.
rigid or inflexible budget. Thus it is not rigid.
2. It operates on one level of activity and It consists of various budgets
under one set of conditions. It assumes for different levels of activity.
that there will be no change in the
prevailing conditions, which is
unrealistic.
3. Here as all costs like - fixed, variable Here analysis of variance
and semi-variable are related to only one provides useful information as
level of activity. So variance analysis each cost is analysed according
does not give useful information. to its behaviour.
4. If the budgeted and actual activity Flexible budgeting at different
levels differ significantly, then the aspects levels of activity facilitates the
like cost ascertainment and price fixation ascertainment of cost, fixation
do not give a correct picture. of selling price and tendering of
quotations.
5. Comparison of actual performance with It provides a meaningful basis of
budgeted targets will be meaningless comparison of the actual
specially when there is a difference performance with the budgeted
between the two activity targets.
levels.