Budgetary control

BUDGETING AND BUDGETARY CONTROL

A budget- is a formal expression of income and expenditure for a given future period.
Budgeting- refers to the mechanism of preparing budgets.
Budgetary control- refers to the process of comparing actual results with budgeted results and analyzing the causes of any variances so as to provide the basis for managerial planning and control.

Advantages of budgetary control
 It ensures the achievement of organizations objectives.
 It compels planning i.e. the management is forced to look ahead and set out a detailed plan for achieving the targets.
 It communicates the ideas and plans in a formal system that ensures that each person affected the plan is aware of his responsibility in the budget process.
 A formal budget may act as a formal authorization to budget managers to incur expenditure.
 It helps to establish a system of control.
 It provides a means of performance evaluation.
 It motivates employees to improve their performance.
 Leads to economy in operations
 Gives motivation to workers
 Serves as a medium of communication i.e. translates goals and targets of the organization in quantitative and monetary terms.
 Encourages management exception (MBE) i.e. The management can concentrate only on the areas where performance is below the targets.
Disadvantages of budgetary control
i) Are prepared using estimated figures which may not be accurate
ii) Installation and operation of a budgetary control system is expensive since it requires technical and qualified staff

iii) Opposition staff i.e. budgets provide a „yard stick‟ against which the workers performance may be measured. Inefficient workers may create difficulties in the operation of the budgetary control systems.
iv) It‟s simply a tool of management and cannot replace the management.
Classification of budgets
Budgets can be classified as follows

Functional budgets
i) Sales budget
ii) Functional budget
iii) Material usage budget
iv) Material purchase budget
v) Labour cost budget
vi) Cash budget
Sales budget
This is a forecast of sales in a given period both in quantity and in value.

Illustration
XY Ltd sells 2 products which are manufactured in one plant during the year 2009, it planned to sell following quantities of each products

Product X sells at Ksh 10 per unit while Y at Ksh 20 per unit.
A study of past experience reveals that XY limited loses 3% of its billed revenue each year due to bad debts.

Required:
prepare sales budget incorporating the given information

Production Budgets
This is an estimate of the quantity of goods that must be produced during the budget period so as to satisfy the budgeted sales and the desired stock levels of finished goods.
i. Estimated sales quantity.
ii. Estimates opening stock of finished goods in units.
iii. Desired closing stock of finished goods in units.
iv. Available physical resources e.g. raw materials.
v. Management policy.

Illustrations
The following information was obtained from the books of PQ ltd for the year ended 31st
Dec. 2009.


Materials usage budgets
This represents the quantity of material required to produce the units in the production budget.

Material purchases budgets.
This is the quantity of materials to be purchased so as to satisfy the material usage budget after adjusting for the opening and closing stocks of raw materials.

Illustration
The sales director of a manufacturing company reported that in year 2011 he expects to sell 54,000 units of a product. The production manager consulted the purchasing Manager and cast his figures as follows:-
2 types of raw materials A and B are required for the manufacture. Each unit of the final product requires 2 kgs of material A and 3 kgs of B.

The estimated balances at the beginning of the period are as follow:
 Finished products 10,000 units
 Material A 12,000 kgs
 Material B 15,000 Kgs.

The balances at the end of the period are expected to be:
 Finished products 14,000 units
 Material A 13,000 kgs
 Material B 16,000 kgs.

Required:
Draw up budgets for the following:
i) Production budget (in units)
ii) Material usage budget (in units)
iii) Material purchase budget (in units)

Solution

Production budget Units
Sales quantity 54,000
Add: desired closing stock of finished goods 14,000
Less: estimated opening stock of finished goods (10,000)
Production budget 58,000

Note – the company must produce large enough to cover what it wants to sell plus what should remain as closing stock of finished goods


Labour cost budgets.
This is the budgeted cost of direct labour required to satisfy budget production quantity. It is determined multiplying the total direct labour hours the labour rate per hour.

Illustration
The management accountant of KCA ltd has presented the following information for the next budget period.

Expected sales quantity 45,000 units Estimated opening stock of finished goods 5,000 units Desired closing stock of finished goods 10,000 units

It is established that the production of the product uses 2 grades of labour: L1 & L2 such that 4 hours of L1 & 2 hours of L2 are required per unit of the final product. The company pays labour at ksh 500 per hour & ksh 750 per hour for L1 & L2 respectively.

Required:
Prepare labour cost budget for KCA ltd.

Solution Production budget
Sales quantity 45,000 units Less: estimated opening stock (5,000 units) Add: desired closing stock 10,000 units
Production quantity 50, 000 units

IV Cash budgets.
This is a forecast of the cash position of a business for a given period and represents cash receipts and payments and also the estimated cash balance at the end of each month of the budget period.

Importance of cash budget
i. It ensures that sufficient cash is available to meet the requirements of the business.
ii. It reveals any expected shortage of cash so as to enable the management to arrange for any overdraft.

iii. It reveals any expected surplus of cash available for investment outside the business.

Illustration
The following information was extracted from the books of PQ ltd regarding its budget for the 2nd Quarter of the year 2010.

Half the sales are for cash. 90% of the credit sales are collected in the month following the month of sale and the balance one month later. Purchases budget for the 2nd quarter (April-June) was 15,000 units, 18,000 units and 25,000 units respectively at ksh 2 per unit. Purchases are made in cash so as to take advantage of a cash discount of 5%. Wages and salaries for the 2nd quarter are budgeted at ksh. 13,000 per month.
Manufacturing and other expenses for the quarter are: Cash expenses Ksh. 9,000
Depreciation Ksh. 15,000 Selling expenses Ksh. 6,000
Administration Expenses Ksh. 4,000 (equally in April and May only)

Required:
Prepare a cash budget for the 2nd quarter.

Master budget
This is the total budget package for an organization. It is the end product of the budget preparation process. It is therefore a summary budget which incorporates its component functional budgets and which is finally approved, adopted and employed. When all the functional budgets are prepared, they can be summarized to produce budgeted profit and loss account and budgeted balance sheet. The budgeted cash flow statement may also be included.

Illustration:
A small manufacturing firm produces one product. The budgeted sales for the month of January 2010 are for 10,000 units at a selling price of Sh. 2,000 per unit. Other details are as follows:

4. Factory overhead is absorbed into units cost on the basis of direct labour hours. The budgeted factory overhead for the month is Sh.1,920,000.
5. The administration, selling and distribution overhead for the month is budgeted at Sh.5,500,000.
6. The company plans a reduction of 50% in quantity of finished stock at the end of the month and an increase of 30% in the quantity of each input component.

Required:
(a) For the month of October 2010
(i) Production quantity budget;
(ii) Materials usage budget
(iii) Materials purchase budget
(iv) Direct labour cost budget

(b) The budgeted profits and loss account.



Fixed/static & flexible budget
A fixed budget is a budget which is drawn to remain unchanged irrespective of the production and sales volume actually realized. It is a static budget which doesn‟t adjust itself to the actual activity level.

A flexible budget on the other hand is draw to adjust to the actual sales and production quantities. In some sense it can be considered to be a revised budget for actual activity realized.

Illustration
Passion Fruit processors Ltd manufactures and retails one-liter cans of passion juice at ksh 800 per can. For the month of April 2000, the company canned and retailed 1350 cans for a net profit of ksh 317,450 based on the cost structure:

Required:
In columnar form and using production achieved:
a. Actual profit and loss statement.
b. Flexible budget profit and loss statement.
c. Without breaking down the resultant variances into their price and efficiency components, a reconciliation of actual and flexed profit or loss.

Solution

Activity
Progressive Products Ltd. plans to commence operations in July 2010. As part of its budgetary control system the company’s operations will be based on quarterly budgets. The following information has been assembled the company as the basis for the preparation of the company’s cash flow projection for the third quarter of 2010.

1. Gross sales are expected to amount to Sh.500,000 for July 2010, increasing at the rate of 20% per month for two months to the end of the quarter and thereafter at the rate of 10% per month to the end of the year.
2. Of the gross sales, 40% is cash sales while the balance is due in the month following the month of sale.
3. It is the company’s policy to mark up sales 25%. Purchase are paid for in the month following the month of purchase.
4. The following expenses are expected to be incurred:

5. Office rent at the rate of Sh.80,000 per quarter is due and payable in arrears at the end of each quarter.

6. The company expects to have a cash balance of Sh.100,000 on July and maintain the same as its minimum. Overdraft facilities have been negotiated and granted the company’s bankers.
Required:
In columnar form, a cash budget for the third quarter of 2010 reflecting any monthly overdraft facility required the company.

BEHAVIORAL ASPECTS OF BUDGETS

Human behavior and budgetary planning and control
An important feature in control in business is that control is exercised the managers over people. Their attitude and response to budgetary planning and control will affect the way in which the business operates.

A budgetary system does not consist only of accounting, forecasting and other management techniques. The success of a budgetary planning and control system depends on the cooperation of those who are to be involved in its operations. Individuals may not always behave in the best interest of the organization or they may be unwilling to strive to achieve the budget as set for the period. This is known as dysfunctional behavior.

A budgetary system should be designed to minimize the occurrence of dysfunctional behavior. This can be achieved if the systems designers and operators bear in mind the behavioral aspects of such systems. The human aspects to be considered are numerous and many of them are unrelated but the following are the most important:

1. Motivational aspects – The process of budget preparation and subsequent performance evaluation budgetary control need to be carried out so as to motivate managers rather than create resentment and adverse reactions. The process should be participative, encourage initiative and responsibility.

A budgetary system will not be successful if individuals do not want to achieve the targets which have been set for their area of responsibility. A lack of the necessary motivation can exist for many reasons including;
 The targets have not taken into account the individual aspiration level-the level of performance that an individual has set as a personal target. If the performance target is set too far above the aspiration level, the individual will reject the budget as unrealistic and will be demotivated. If the target is set too far below the aspiration level the individual may also be demotivated the lack of challenge and may then work at a level of performance below that which could otherwise have been achieved. A department or section of an organization can also have an

aspiration level which will be the collective results of all the individuals‟ aspiration levels.
 There is inadequate provision for the recognition of achievement- When performance levels have been achieved or exceeded, it is important that mangers acknowledge this and reward the relevant people. The reward need not necessarily be a financial one. A good manager will be able to motivate staff with appropriate psychological reward-simply acknowledging the achievement may be sufficient.

i) Participation as a motivator
Participation promotes common understanding regarding objectives and makes the acceptance of organizational goals the employees much more likely.

If people are genuinely involved, they feel part of the team and become highly motivated to achieve the budgets.

ii) Use of budget targets as a motivator
Once budgets have been prepared, they become targets and can be used to motivate employees to achieve a high level of performance. The targets set should be realistic, challenging and achievable. Ideal or unrealistic targets are demotivating since they will always lead to adverse variances. Low targets are also demotivating since they are easy to achieve.

iii) Performance evaluation as a motivator
Employees who are evaluated are motivated to do their best.

2. Communication- targets must be communicated to those who are expected to achieve them. People cannot be expected to perform against the target they do not know about. It also important that target are understood- otherwise they will be rejected. Communication of actual results is also important; this is known as feedback.

3. Participation- participative budgetary system is always the most successful. If the system is dictatorial, with imposed budgets, there is more likely to be dysfunctional behavior. Individual managers should not simply be issued with their budgets without consultations. They should be consulted about their budget during the planning process. Managers are then more likely to accept the target contained in the budget when it is published.

A participative budgetary system will also encourage goal congruence. This exists when the budgetary system motivates individuals or groups to take actions that achieve their own personal goals while at the same time achieving those of the organization. The

system is designed so that there is a relationship between the company‟s goals and the individuals‟ goals. Goals are more likely to be congruent if individuals or groups have been involved in setting their own budgets.

Budget Setting Styles
1 Imposed style of budgeting
In this style, senior managers prepare budgets with little or no input from operating personnel or operational managers. The budget is then imposed on the employees who have to work with the budgeted figures.

Imposed budgets are effective in the following circumstances.
i) In newly formed organizations
ii) In very small businesses
iii) During periods of economic hardship
iv) When operational managers lack budgeting skills
v) When organization‟s different units require very precise co-ordination

Advantages of imposed budgets
i) They increase the probability of incorporating organization‟s strategic plans.
ii) They utilize senior management‟s awareness of total resource availability
iii) They decrease the period of time taken to prepare budgets
iv) They decrease the possibility of undesirable input from inexperienced lower level employees.

Disadvantages of imposed budgets
i) Morale of other employees is reduced since they are not involved in the preparation of budgets.
ii) Hamper creativity of lower level management
iii) May not be fully accepted the employees
iv) May kill team spirit

2 Participatory style of budgeting
Budgets are prepared lower level managers and then submitted to senior managers for approval, usually without significant adjustments
These budgets are based on the lower level manager‟s perceptions of what is achievable and the associated resource requirements.
Participatory budgets are effective in the following circumstances:

i) In well established organizations
ii) In very large businesses
iii) During periods of economic affluence

iv) When operational managers have strong budgeting skills
v) When organization‟s departments are allowed to operate independently.

Advantages of participative budgets
i) Information from employees most familiar with their departmental needs and constraints is included.
ii) Morale and motivation of employees is improved.
iii) Leads to acceptance and commitment to organizational goals
iv) They are more realistic than imposed budgets
v) Specific resource requirements are included.

Disadvantages
i) They are time consuming
ii) Managers may introduce budgetary slacks i.e none challenging or easy to achieve targets.
iii) They can support empire building department heads.

3 Negotiated style of Budgeting
– Different levels of management often agree on budgets through negotiations.
– Operational managers may negotiate with senior managers on what they consider to be unreasonable or unrealistic in the imposed budgets.
– Likewise, senior managers usually review and revise budgets presented to them under the participative approach through a process of negotiation with lower level managers.
– The result is a negotiated budget.

Problems Associated with Budgeting
a) Budgets are developed round existing organizational structures and departments which may be inappropriate for current conditions and may not reflect the underlying economic realities.
b) They may introduce rigidity and hamper creativity in the organization
c) The budgetary system, perhaps because of undue pressure or poor human relations, may cause antagonism and decrease motivation.
d) There may be too much reliance on the technique as a substitute for good management.
e) Problems of setting the levels of attainment to be included in budgets.
f) There are inherent lags and delays in the system. Budgets and resulting variances may be of little value in guiding current operations if there are delays in getting feedback.

g) Managers may base future plans on past results instead of looking at alternatives options of achieving the objectives.
h) Managers may put in only just enough effort to achieve budget targets without trying to beat the targets.

Incremental budgeting
Before an annual budget is prepared, a base should be chosen from which the process will begin. The traditional approach is to base the current budget on the current year‟s results plus an extra amount for estimated growth or inflation for the next period. This method is known as incremental budgeting.

Incremental budgeting is appropriate if current operations are as effective, efficient and economical as possible. It is however considered to be a weak approach to budgeting because it encourages slack and wasteful spending on non essential activities. Through incremental budgeting, past inefficiencies are perpetuated.

Limitations of the traditional incremental budgeting:
 It assumes that the basic structure of the budget will remain unchanged
 It focuses on only the existing uses of the resources

 To ensure that inefficiencies are not concealed in the budgets, an alternative approach to budgeting called zero based budgeting is employed.

Zero-Based Budgeting (ZBB):
Zero based budgeting is a cost benefit approach where it‟s assumed that the cost allowance for an item is zero and will remain so until the manager responsible justifies the existence of the cost item and the benefit the expenditure brings.

Traditionally budgets are prepared taking current years estimates as the base and then adjusting for the impact of inflation, proposed increase in the level of activity, expected increase in the resources. This means that budgets for each year are always a percentage of previous year‟s budget.

Zero based budgeting on the other hand requires each manager to justify his entire budget request in detail from scratch hence (zero base). Zero-base refers to a nil budget as the starting point. It starts with the premise that the budget for the next period is zero so long as the demand for an activity is not justified. The assumption is that without such a justification no spending will be allowed. Each manager is responsible to justify why the money should be spent at all and to explain in detail as to what would happen if the proposed activity is not carried out and no money is spent thus each

manager is required to make a cost benefit analysis of each of the activities under his control.

Zero based budgeting is best applied to service and support expenditure including administration, marketing, personnel, research and development, finance and accounting etc.

Implementing zero based budgeting
The overall process of implementing zero based budgeting can be subdivided into 3 stages:

a) Definition of decision packages- a decision package refers to an activity or a group of activities for which a single manager has the responsibility for successful performance. The decision package is specified the managers concerned and must show details of anticipated cost and benefits expected. There are two types of decision packages:

i. Mutually exclusive decision package- are alternative activities required to carry out the same job
ii. Incremental decision packages- are complementary activities.

b) Packages are evaluated and ranked-when the decision packages have been prepared, the management will rank all the packages on the basis of their benefit to the organization. This ranking provides a basis for allocation of resources between activities.

c) Resources are allocated- the packages are accepted in the ranked priority sequence and then resources are allocated.

Advantages of zero based budgeting
i. It results into a more efficient allocation of resources to activities.
ii. It focuses on the relationship between the input of recourses and output of benefits.
iii. It develops a questioning attitude and makes it easier to identify inefficient obsolete or less cost effective operations
iv. The zero based budgeting process leads to greater staff and management knowledge of operations of the organization and can increase motivation.
v. It provides a budgeting and planning tool for management which responds to changes in the business environment; obsolete items of expenditure and activities are identified and ceased.
vi. It adds a psychological impetus to employees to avoid wasteful expenditure.

Disadvantages of zero-based budgeting
i. There is considerable management skill required in both drawing up the decision packages and for the ranking process. Such skills may be lacking in the organization.
ii. It may encourage the wrong impression that all the decisions have to be made in the budget. Circumstances may change and new opportunities and threats can arise at anytime and organizations must be flexible enough to deal rapidly with these circumstances when they occur.
iii. Zero based budgeting may be unacceptable to staff who may prefer the status quo and who may see the detailed examination of alternatives, cost and benefits as a threat and not a challenge.
iv. There are problems in the ranking due to subjectivity.
v. It emphasizes short term benefits to the detriment of the long term ones.

Recommended texts for further reading
Costing T. Lucey
Costing, An Introduction, Colin Drury Wheldon‟s, “Costing Simplified”
Colin Drury, “Management and Cost Accounting”
Bhabatosh Banerjee, “Cost Accounting Theory and Practice”

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