Budgeting

A BRIEF WRITE-UP ON BUDGETING PROCESS WHAT IS BUDGETING :- Budgeting is a tool of planning. Planning involves specification of the basic objectives that the organization will pursue and the fundamental policies that will guide it. In operational terms, it involves four steps: (i) Objectives defined as the broad and long -range desired state/position of the firm, (ii) Specified goals or targets in quantitative terms to be achieved in a specified period of time, (iii) Strategies or specific methods/course of action to achieve these goals, and (iv) Budgets to convert goals and strategies into annual operating plans. MAIN OBJECTIVES OF BUDGETING :- As a tool, budgets serve as a guide to the conduct of operations and a basis for evaluating actual results. The main objectives of budgeting are : i) Explicit statement of expectations One purpose of budgeting is to state expectations in formal terms so that most of the underlying assumptions may be identified. Budgets explicitly state the underlying assumptions and goal and the means of attaining it. To illustrate, if the sales target (projected sales) for any given period is Rs 5,00,000, the budget will not only indicate this figure but will also give details about the assumed prices, quantity, sales efforts, and so on. This explicit statement of assumption is one of the most important contributions of budgeting for managerial planning and control. ii) Communication Another purpose of budgeting is to communicate or inform others of the goals and methods selected by top management. In other words, the employees should be aware well in advance of the level of performance expected of them. It is for this reason that a budget is viewed as a means of communicating to the employees the level of performance expected of them so that the goals set out in the budget can be accomplished. iii) Coordination Coordination is a major function of budgeting. Budgets should be drafted in such a way that the operations of the various departments are related to each other for the achievement of the overall goal. Apart from the interdepartmental reconciliation, budgets also provide for flexibility to accommodate plans and operations to unexpected situations. iv) Expectations as a framework for judging performance Finally, a budget establishes expectations as a framework for judging employee performance. A budget, as observed earlier, defines the goals, the means of implementing them and the level of performance by the employees. The extent to which employees have succeeded in the task assigned to them, can be judged on the basis of a comparison of the actual performance/achievement with the budget. If the actual performance equals or exceeds the budgeted level, it may be termed satisfactory, otherwise not. DEFINITION OF A BUDGET AND ITS VARIOUS TYPES :- A budget is defined as a ‘comprehensive and coordinated plan, expressed in financial terms, for the operations and resources of an enterprise for some specified period in the future.’ A comprehensive or overall budget can be broadly classified as :- i) Operating Budget & Financial Budget ii) Fixed Budget & Flexible Budget Operating Budget : Operating budgets relate to the physical activities/operations of a firm such as sales, production, purchasing, debtors collection and creditors payment schedules. The different types of an operating budget are Sales budget, Production budget, Purchase budget, etc. Financial Budget : Financial budgets are concerned with expected cash receipts/disbursements, financial position and results of operations. The different types of a financial budget are Cash budget, Revenue budget, Capital budget,etc. Fixed Budget : Budgets prepared at a single level of activity, with no prospect of modification in the light of changed circumstances , are referred to as fixed budgets. The major weakness of a fixed budget is their inability to show the potential variability of various estimates used in the preparation of the budget. They are, therefore, not useful in an uncertain and unpredictable environment. Flexible Budget : A flexible budget estimates costs at several levels of activity. Its merit is that instead of one estimate, it contains several estimates/plans in different assumed circumstances. It is a useful tool in real world situations, that is, unpredictable environment. Here we will be discussing in detail the Revenue & Capital Budgets which are very important from any organisation’s point of view. Revenue Budget : Revenue budget estimates the profitability of an organization by taking into account the estimates of all the future income and expenses for a given period of time, which is generally of one year. As it is generally prepared for a period of one year, Revenue Budget is also termed as a short-term budget. It is a very useful monitoring tool as it sets the target for expenses to be incurred in a particular financial year and provides the organization with a ceiling limit of expenditure which should not be crossed by any means and at any cost. Revenue budget is a very important tool in the hands of management to monitor the financial performance of an organization for a given period of time. Capital Budget : Capital budget, also known as a long-term budget, pertains to fixed/long-term assets which by definition refer to assets which are in operation, and yield a return, over a period of time, usually, exceeding one year. They, therefore, involve a current outlay or series of outlays of cash resources in return for an anticipated flow of future benefits. In other words, the system of capital budgeting is employed to evaluate expenditure decisions which involve current outlays but are likely to produce benefits over a period of time longer than one year. These benefits may be either in the form of increased revenues or reduced costs. Capital budgeting decisions are of paramount importance to any organization as they affect the profitability of a firm and also have a bearing on its competitive position. TYPES OF BUDGETING :- Responsibility Budgeting : When an operating or functional budget is structured around responsibility centres, it is referred to as a responsibility budgeting. The head of responsibility centre is expected to prepare a budget for the cost over which he has the control and authority to incur, and he is expected to operate within the limits of this budget. However, they are not accountable for cost which are not under his or her control. For example, a foreman is not held responsible for the excess price paid by the purchase manager, he can be held liable for the excessive usage of material if any. Responsibility Centre : Responsibility centre is defined as “a segment of organization headed by a designated individual responsible for the achievement for the specified objectives set for that segment.” In other words, it is a unit of function of an organization headed by a manager having direct responsibility for its performance. Responsibility centre emphasizes on the division of organization among different sub-units in such a way that each sub-unit is responsibility of an individual manager. The basic theme of this approach is that a manager should be held responsible for those activities, which are under his or her direct control. Types of Responsibility centre : Three types of responsibility centres can be established for management control purposes – a cost or expense centre, a profit centre, and an investment centre. i) Cost or expense centre Cost or expense centre is a segment whose financial performance can be measured in terms of cost. The analysis of performance is restricted to the use of resources in the divisions, what has been achieved in the consequences of consuming those resources is not considered. Cost is an index of performance, therefore expense centres are divisional performance measures, and relevant in situations, where the revenue of the responsibility centres cannot be reliably measured or the segment produced only one single product or if the divisional manager has to produce a stated quantity of output at the lowest feasible cost. ii) Profit centre Profit centre is the segment of an organization in which financial performance is measured on the basis of profit (both revenue and expenses or cost). In general, most responsibility centres are viewed as profit centres taking the difference between revenues and expenses as profit. The manager holds responsibility for both revenues and expenses. The main objective of profit centre manager is to maximize the centre’s profit. iii) Investment centre Investment centre is a segment of activity or area held responsible for both profits and investment. Here the manager is responsible not only for profit but also the assets under his disposal. In other words, investment centres consider not only the cost and revenues but also the assets used in the division. As a responsibility centre, the performance of a unit would be measured in relation to the revenue/profits and the assets employed in the division. The essence of investment centre analysis is that it shows the relationship between the profit and the assets that are used to generate profit. Activity-Based Budgeting :- The logical thrust behind all activity-based techniques is that cost control and management should focus on the outputs of a process rather than on the inputs to that process. To manage costs more effectively, the organizations that have adopted the Activity based costing (ABC) have also adopted the Activity based budgeting (ABB). The aim of ABB is to authorize the supply of only those resources that are needed to perform activities required to meet the budgeted production or sales volume. Whereas ABC (Activity based costing) assigns the resource expenses to activities and then uses activity cost drivers to assign activity costs to cost objects (such as, products, services, or customers), ABB (Activity based budgeting) is the reverse of this process. Cost objects are the starting point; their budgeted output determines the necessary activities, which are then used to estimate the resources that are required for the budget period. Steps involved in Activity-Based Budgeting :- Activity-based budgeting (ABB) involves the following five stages :- 1) Estimate the production and sales volume by individual products and customers; 2) Estimate the demand for the organizational activities; 3) Determine the resources that are required to perform organizational activities; 4) Estimate for each resource the quantity that must be supplied to meet the demand; 5) Take action to adjust the capacity of resources to match the projected supply. The major feature of the Activity based budget is the enhanced visibility arising from showing the outcomes, in terms of cost drivers from the budgeted expenditure. This information is particularly useful in planning and estimating future expenditure. Application of Activity-based Budgeting :- Let us now look at how ABB can be applied in a practical situation. Assume that ABB stage one and two as outlined above resulted in an estimated demand of 2800 orders for the processing of the ‘standard customer orders’ activity. For ABB stage three, it is assumed that each member of staff can process on average 50 orders per month, or 600 orders per year. Therefore 4.67 (2800/600) staff members are required for the supply of this resources (that is stage three as outlined above). The fourth stage converts the 4.67 staff resources into the amount that must be supplied, which are 5 staff members. Now let us assume that current capacity or supply of resource committed to the activity is 6 staff members at Rs 25000 per annum, giving a total amount of Rs 150000. Management is therefore made aware that staff resources can be reduced by Rs 25000 per annum, by transferring one staff member to other activities where staff resources need to be expanded. Performance Budgeting :- Performance budgeting is mostly used in the Government departments / organizations. Performance budgets are based on functions, programmes, and activities and primarily focus on work-cost measurement and managerial efficiency. The basic objective of performance budgeting is to provide output-oriented budget information with a long-range perspective to allocate resources more effectively. A performance budget is one which presents :- ➢ The purposes and objectives for which funds are requested, ➢ The costs of activities proposed for achieving these objectives, ➢ Quantitative data measuring the accomplishments, and ➢ Work performance under each activity. For example, Ministry of Transport & Shipping should attempt budgets for activities like :- ➢ Development & maintenance of roads ➢ Road Transport ➢ Inland Water transport ➢ Ship Building Stages of Performance Budgeting :- 1. Objectives : The objective of individual activities is clearly spelt out in quantitative and monetary terms as far as possible. 2. Analysis : The long-term strategy and short-term tactics for achieving the desired objectives are considered. In addition, possible alternative activities are identified and costs and benefits of the alternative activities are worked out. 3. Classification : After the analysis, those activities taken for implementation are classified with reference to a prescribed classification system for allocation of resources. 4. Organization : The roles of different implementing agencies in achieving the specified objectives are clearly demarcated and financial rules and accounting system are modified to implement the defined activities more effectively. 5. Evaluation : A proper system for evaluating the implementation of activities is predetermined. Desired information system and reporting system relating to financial, physical, and economic data is also installed to monitor the desired activities during execution. The projects should be subject to thorough evaluation even after their completion. Each performance budget shows the organization structure and the broad set of objectives that the approach and work of the administrative agency should achieve. Planning Programme Budgeting System (PPBS) :- Programme budgeting is widely used in the public sector and non-profit organizations to avoid excessive costs and to ensure that expenditure is focused on programmes and activities that generate the most beneficial results. The aim of PPBS is to enable the management of a non-profit organization; to make more informed decisions about the allocation of resources to meet the overall objectives of the organization. First, overall objectives are established. Secondly, the programmes that might achieve these objectives are identified. Finally, the cost and benefit of each programme are determined so that budget allocations can be made on the basis of the cost benefit of the different programmes. The steps involved in PPBS are as given below :- 1. Specify the objectives of the various programmes; 2. Measure the output in terms of the objectives; 3. Determine the total costs of the programmes for several future periods; 4. Analyse alternatives, and go for those with the greatest benefit in terms of the objectives; and 5. Systematically implement the selected alternatives. While traditional budgeting emphasizes on the method and means used, PPBS emphasizes on the purposes and the objectives of the programme. PPBS is the systematic identification and analysis of alternatives, which are examined in relation to costs and benefits, and provide the decision makers with relevant data, appropriately structured into object-oriented format for decision-making. It allows the management to make better decisions regarding strategic allocation of resources. Zero-Base Budgeting :- Like all budgeting techniques, zero-base budgeting (ZBB) is also designed to be used in setting the levels of future expenditure. It can be defined as “a method of budgeting whereby all the activities are re-evaluated and 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” (i.e. all activities are re-evaluated each time when a budget is set). This approach is particularly pertinent in public sector organizations where, funds are determined by tax revenues and government grants and allocations, i.e. the income of the organization is exogenously set. The aim of the fund holder is to achieve the best service levels possible within the given budget. Advantages of ZBB :- 1) ZBB avoids the complacency inherent in the traditional incremental approach, where it is simply assumed that future activities will be very similar to current ones. 2) ZBB encourages a questioning approach, by focusing attention not only on the cost of an activity, but also on the benefits it provides, as well as the relative benefits of different types and levels of expenditure. Forcing managers to articulate benefits encourages them to think clearly about their activities. 3) Preparation of the decision packages, will normally require the involvement of many employees, and thus provides an opportunity for their views to be considered. This involvement may produce useful ideas, and promote job satisfaction amongst the wider staff. Zero base budgeting reverses the working process of traditional budgeting. While traditional budgeting starts with previous year expenditure level as a base, in Zero-base budgeting, no reference is made to previous level of expenditure, and a convincing case is made for each decision unit to justify the budget allotment for that unit during that period. Criticism of Zero Base Budgeting :- 1) Defining the decision units and decision packages is the first difficulty encountered by companies introducing zero base budgeting. In conventional budgeting, companies used to think in terms of cost centres, etc. For zero-base budgeting, a very exhaustive analysis is to be attempted. 2) Zero base budgeting has been referred to as a very threatening process. In this process, the managers have to justify their budget requests in complete detail taking nothing for granted. The managers have to justify each item of budget or the budget allotment relating to their decision unit. 3) Zero base budgeting requires a lot of training for managers. If managers do not understand correctly the idea at the back of zero base budgeting, it cannot be introduced successfully. Behavioural Aspects of Budgeting :- In the previous discussion, the emphasis has been on economic considerations of budgeting. There is, however, another very important aspect of budgeting or budgetary control systems and that is, its impact on the human beings who will operate and be judged by those systems. It has resulted from the study that the personal relationships in the workplace have percolated (entered) into the field of management accounting. It is now recognized that failure to consider the effect of control systems on the people concerned could result in a lowering of morale and a reduction of motivation. Behavioural aspect in budgeting includes the following :- a) Motivation and cooperation To be fully effective, any system of control must provide for motivation and incentive. If this requirement is not satisfied, managers will approach their responsibilities in a very cautious and conservative manner. It is often found that adverse variances attract investigation and criticism but there is no incentive to achieve favourable variances. Therefore, the success of a budgetary control system depends on the people who operate and are affected by it. They must work within the system in an understanding and cooperative manner. This can be achieved by involving individuals in all stages in the budget process. However, it is commonly found that :- ➢ A budget is used as a pressure device. If the budget is perceived as a stick with which to beat people then it will be sabotaged in all sorts of subtle ways. ➢ The budgeting process and subsequent budgetary control exercises induce competition between individual departments and executives. Managers may be induced to do things in order to meet budget, which are not in the best interests of the business as a whole. b) Failure of goal congruence Performance evaluation is essential element of budgetary control in which actual results are compared with budget or standard in order to determine whether performance is good or bad. What is being evaluated is not just the business operation but also the managers responsible for it. Compliance with budget is enforced by a variety of negative and positive sanctions. When adverse variances are reported for an operation, then this implies poor performance by the manager of the operation. If he is unable to correct or explain away the adverse variances, then he may suffer negative sanctions like he may have to forego salary increases, or he may be demoted to a less prestigious post. Positive inducements may be offered to encourage managers to avoid adverse variances. A manager who meets budget may be granted a performance related salary bonus, promotion, a new company car. c) The budget as a pot of cash In some companies or environments, managers consider the budget as a sum of money, which has to be spent. This arises particularly in service departments, public sector organizations, or government organizations, the performance of which is measured by the comparison of actual and budget spending. The head of govt. street cleaning department may be given an annual budget of Rs 300000 to clean the streets. The head knows that he will be punished if he spends more than Rs 300000 in the year, but he also knows that if he spends less than Rs 300000 in the year then his budget will probably be reduced next year. Such a reduction will involve a personal loss of status in the organization and will make his job harder in the next year. d) Budget Negotiation Budgets are normally arrived at by a process of negotiation with the managers concerned. A budget may actually be initiated by departmental managers and then corrected as a result of negotiation with the budget officer. Clearly, a manager has an incentive to negotiate a budget that is not difficult to achieve. This produces a phenomenon known as ‘padding the budget.’ A manager will overstate the costs required to achieve objectives. If the manager succeeds in padding his budget, then the whole control exercise is damaged. Comparison of actual with budget gives no meaningful measure of performance and the manager is able to include inefficiencies in his operation if he wishes. A successful manager becomes one who is a hard negotiator, but the problem with this is that the negotiations in question are between colleagues and not with customers. ‘In-fighting’ may become entrenched in the management process. e) Influence on accounting policies Any management accountant who has been engaged in the preparation of financial control reports will be familiar with attempts by managers to influence the accounting policies. For example, the apportionment of indirect costs between departments often contains subjective elements. Should security costs be apportioned on the basis of floor space or staff members' The manner in which the indirect costs are apportioned can have a considerable impact on how the performance of individual departments is perceived; this position creates the scope and incentive for managers to argue over accounting policies. If a manager perceives that his department’s performance is falling below budget, then he may shift through the costs charged to his department and demand that some may be reclassified and charged elsewhere. The time and energy that goes into this kind of an exercise has to be diverted to the regular management of the business.