Budgets and Budgetary Control

By: CA Kapileshwar Bhalla

Learning Objectives

Understand the objectives and importance of budgeting and budgetary control

Understand the Advantages and disadvantages of budgetary control

Differentiate between various types of budgets

Understand the process of preparation of budgets

Meaning of Budget

“A financial and/or quantitative statement, prepared and approved prior to a defined period of time of the policy to be pursued during that period for the purpose of attaining a given objective. It may include income, expenditure and employment of capital”.

The Chartered Institute of Management Accountants of England and Wales

Objectives of Budgeting …..

Planning

It not only motivates employees to attain goals but also improves overall decision making. During the planning phase of the budget process, all viewpoints are considered, options identified, and cost reduction opportunities assessed. This process may reveal opportunities or threats that were not known prior to the budget planning process.

Directing

Once the budget plans are in place, they can be used to direct and coordinate operations in order to achieve the stated targets.

Controlling

As time passes, the actual performance of an operation can be compared against the planned targets. This provides prompt feedback to employees about their performance. If necessary, employees can use such feedback to adjust their activities in the future.

Meaning of Budgetary Control

“Budgetary control is the establishment of budgets relating to the responsibilities of executives of a policy and the continuous comparison of the actual with the budgeted results, either to secure by individual action the objective of the policy or to providea basis for its revision.”

The Chartered Institute of Management Accountants of England and Wales

Advantages of Budgetary Control System1. The use of budgetary control system enables the management of a

business concern to conduct its business activities in the efficient manner.

2. It is a powerful instrument used by business houses for the control of their expenditure.

3. It in fact provides a yardstick for measuring and evaluating the performance of individuals and their departments.

4. It reveals the deviations to management, from the budgeted figures after making acomparison with actual figures.

5. Effective utilisation of various resources like—men, material, machinery and money—ismade possible, as the production is planned after taking them into account.It helps in the review of current trends and framing of future policies.

6. It creates suitable conditions for the implementation of standard costing system in abusiness organisation.

7. It inculcates the feeling of cost consciousness among workers.

Limitations of Budgetary Control System1. Based on Estimates: Budgets may or may not be true, as they are

based on estimates.2. Time factor: Budgets cannot be executed automatically. accuracy in

budgeting comes through experience. Management must not expect too much during the development period.

3. Co-opertaion Required: Staff co-operation is usually not available during budgetary control exercise. The success of the budgetary control depends upon willing co-operation and teamwork,

4. Expensive: Its implementation is quite expensive. No budgetary programme can be successful unless adequate arrangements are made for supervision and administration.

5. Not a substitute for management: Budget is only a managerial tool. It cannot substitute management.

6. Rigid document: Budgets are considered as rigid document. But in reality, firm’s affairs continuously changes under inflationary pressure and changing government policies.

Types of Budgets

Types of Budgets

Period Wise

Function Wise

Capacity Wise

Category I

Capacity Wise

Fixed Flexible

Category II

Capacity Wise

Long Term Short Term Current

Category III

Function Wise

Production

Material Consumption

Sales

Material Purchase

Direct Labour Factory OH

Administration OH

Selling & Distribution

OH

Cash Budget

Category I Fixed Budget

“a fixed budget, is a budget designed to remain unchanged irrespective of the level of activity actually attained”.

Chartered Institute of Management Accountants of England

Category II Flexible Budget

”a flexible budget is defined as a budget which, by recognizing the difference between fixed, semi-variable and variable costs is designed to change in relation to the level of activity attained.”

Chartered Institute of Management Accountants of England,

Fixed vs Flexible (definition)

It is a Budget designed to remain unchanged irrespective of the level of activity actually attained.

It is a Budget, which by recognising the difference between fixed, semi-variable and variable costs is designed to change in relation to level of activity attained.

Rigidity

It does not change with actual volume of activity achieved. Thus it is known as a Rigid or Inflexible budget.

It can be re-casted on the basis of activity level to be achieved. Thus it is not rigid.

Level of Activity

It operates on one level of activity and under one set of conditions. It assumes that there will be no change in the prevailing conditions, which is unrealistic.

It consists of various budgets for different level of activity

Effect of variance analysis

Variance Analysis does not give useful information as all Costs (fixed, variable and semi-variable) are related to only one level of activity.

Variance Analysis provides useful information as each cost is analysed according to its behaviour.

Use for Decision making

It the budget and actual activity levels differ significantly, then aspects like cost ascertainment and price fixation do not give a correct picture.

It facilitates the ascertainment of cost, fixation of selling price and submission of quotations.

BASED ON TIME PERIOD:

Long Term Budget Budgets which are prepared for periods longer than a

year are called Long -Term Budgets. Such Budgets are helpful in business forecasting and

forward planning. Examples: Capital Expenditure Budget and R&D

Short- Term Budget. Budgets which are prepared for periods less than a

year are known as Short- Term Budgets. Such Budgets are prepared in cases where a specific

action has to be immediately taken to bring any variation under control. Example: Cash Budget.

BASED ON CONDITIONS:

Basic Budget A Budget, which remains unaltered over

a long period of time, is called Basic Budget.

Current Budget A Budget, which is established for use

over a short period of time and is related to the current conditions, is called Current Budget.

Based on Coverage

Functional Budget Budgets, which relate to the individual

functions in an organisation, are known as Functional Budgets, e.g. Purchase Budget, Sales Budget, Production Budget, Plant-Utilisation Budget and Cash Budget.

Master Budget It is a consolidated summary of the various

functional budgets. It serves as the basis upon which budgeted Profit and Loss Account and forecasted Balance Sheet are built up.

EXAMPLE 1The Sales Director of a manufacturing company reports that next year heexpects to sell 50,000 units of a particular product.The Production Manager consults the storekeeper and casts his figuresas follows: Two kinds of raw materials, A and B, are required for manufacturing theproduct. Each unit of the product requires 2 units of A and 3 units of B.The estimated opening balances at the commencement of the next yearare –Finished product: 10,000 units, A: 12,000 units.

B: 15,000 uints.The desirable closing balances at the end of the next year are: Finished products: 14,000 units, A: 13,000 units.

B: 16,000 units. Draw up a quantitative chart showing Materials Purchase Budget for thenext year.

Answer

Production Budget

Sales 50,000Add Closing Stock 14,000Less Opening Stock 10,000

54,000

Material Purchase Budget

Particulars A B Consumed 1,08,000 1,62,000Add Closing stock 13,000 16,000Less Opening stock 12,000 15,000

1,09,000 1,63,000

Example 2

AK Limited produces and sells a single product. Sales budget for calendar year 2012 by a quarters is as under:

Quarters I II III IVNo. of units to be sold 18,000 22,000 25,000 27,000

The year is expected to open with an inventory of 6,000 units of finished products and close with inventory of 8,000 units.

Continued: Production is customarily scheduled to provide for70% of the current quarter’s sales demand plus 30% of thefollowing quarter demand. The budgeted selling price per unit is ` 40The standard cost details for one unit of the product are as follows:

Variable Cost ` 34.50 per unitFixed Overheads 2 hours 30 minutes @ ` 2 per hour based on a budgeted production volume of 1,10,000 direct labour hours for the year. Fixed overheads are evenly distributed through-out the year.

You are required to:(i) Prepare Quarterly Production Budget for the year.(ii) In which quarter of the year, company expected to achieve break-

even point.

Production Budget (i) I II III IV Total

Sales dd (units) 18,000 22,000 25,000 27,000 92,000

1 Opening Stock 6,000 7,200 8,100 8,700 30,000

2 70% of Current Qt

12,600 15,400 17,500 18,900 64,400

3 30% of Next Qt 6,600 7,500 8,100 7,400 29,600

4 Total Production

19,200 22,900 25,600 26,300 94,000

5 Closing Stock 7,200 8,100 8,700 8,000 32,000

Part (ii) Break Even Point = Fixed Cost/ PV Ratio=220000/13.75% = 1600000 or 40000 units. P/V Ratio = (40 - 34.50 = 5.50)/40 × 100 =13.75%

(Or, Break Even Point= Fixed Cost/ Contribution = 2,20,000/5.50 = 40,000 Units)

Total sales in the quarter II is 40000 equal to BEPmeans BEP achieved in II quarter.

Example 3

Action Plan Manufacturers normally produce 8,000 units of their product in a month, in their Machine Shop. For the month of January, they had planned for a production of 10,000 units. Owing to a sudden cancellation of a contract in the middle of January, they could only produce 6,000 units in January. Indirect manufacturing costs are carefully planned and monitored in the Machine Shop and the Foreman of the Shop is paid a 10% of the savings as bonus when in any month the indirect manufacturing cost incurred is less than the budgeted provision. The Foreman has put in a claim that he should be paid a bonus of Rs. 88.50 for the month of January. The Works Manager wonders how any one claim a bonus when the company has lost a sizeable contract. The relevant figures are as under:

Indirect Manufacturing Expenses for a Planned for Actuals in Costs Normal month January January

Rs. Rs. Rs. Salary of Foreman 1,000 1,000 1,000Indirect Labour 720 900 600Indirect Material 800 1,000 700Repairs and Maintenance 600 650 600Power 800 875 740Tools Consumed 320 400 300Rates and Taxes 150 150 150Depreciation 800 800 800Insurance 100 100 100

5,290 5,875 4,990Do you agree with the Works Manager ? Is the Foreman entitled to any bonus for the performance in January ? Substantiate your answer with facts and figures.

Answer

Working notes :Indirect labour cost per unit 720 =0.09P.

8,000Thus,Indirect labour for 6,000 units = 6,000 x

0.09P= 540.

Indirect material cost per unit= 0.10P {800/8,000}

Thus, Indirect material for 6,000 units = 6,000 × 0.10P = 600

According to high and low point method of segregating semi-variable cost into fixed and variable components, following formulae may be used.

Variable cost of repair and maintenance per unit=

Change in expense level/Change in output level= 0.025 p

For 8,000 units Total Variable cost of repair and maintenance= 0.025 x 8000 = 200Fixed repair & maintenance cost= 400 Hence at 6,000 units output level, total cost of repair and maintenance should be

= 400 + 0.025 × 6,000 units= 400 + 150 = 550

Variable cost of power per unit = 0.0375 pFor 8,000 unitsTotal variable cost of power = ` 300Fixed cost = ` 500Hence, at 6,000 units output level, total cost

of power should be= ` 500 + ` 0.0375 × 6,000 units= ` 500 + ` 225 = ` 725

Tools consumed cost for 8,000 units = ` 320Hence, tools consumed cost for 6,000 units =

(` 320/8,000 units) × 6,000 units= ` 240

Answer Salary of foreman Fixed 1,000Indirect labour Variable 540(Refer to Working note)Indirect material Variable 600(Refer to Working note)Repair and maintenance Semi-variable 550(Refer to Working note)Power Semi-variable 725(Refer to Working note)Tools consumed Variable 240(Refer to Working note)Rates and taxes Fixed 150Depreciation Fixed 800Insurance Fixed 100

4,705

Conclusion :

The above statement of flexible budget clearly shows that the concern’s expenses in the month of January have increased from ` 4,705 to ` 4,990. Under such circumstances the Foreman of the company is not at all entitled for any performance bonus in January.

Lesson Summary

We have understood:

Various kinds of BudgetsDistinction in terms of Flexible and Fixed Budgets How to make flexible budgetsHow to make functional budgets

Thank you