Sunday, September 22, 2013

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.

Essentials of Effective Budgeting:
A budgetary control system can prove successful only when certain conditions and attitudes exist, absence of which will negate to a large extent the value of a budget system in any business. Such conditions and attitudes which are essential for effective budgeting are as follows:
a)      Support of Top Management: If the budget system is to be successful, it must be fully supported by every member of the management and the impetus and direction must come from the very top management. No control system can be effective unless the organisation is convinced that the top management considers the system to be import.

b)      Participation by Responsible Executives: Those entrusted with the performance of the budgets should participate in the process of setting the budget figures. This will ensure proper implementation of budget programmes.

c)       Reasonable Goals: The budget figures should be realistic and represent reasonably attainable goals. The responsible executives should agree that the budget goals are reasonable and attainable.

d)      Clearly Defined Organisation: In order to derive maximum benefits from the budget system, well defined responsibility centers should be built up within the organisation. The controllable costs for each responsibility centres should be separately shown.

e)      Continuous Budget Education: The best way to ensure the active interest of the responsible supervisors is continuous budget education in respect of objectives, potentials & techniques of budgeting. This may be accomplished through written manuals, meetings etc., whereby preparation of budgets, actual results achieved etc., may be discussed.

f)       Adequate Accounting System: There is close relationship between budgeting and accounting. For the preparation of budgets, one has to depend on the accounting department for reliable historical data which primarily forms the basis for many estimates. The accounting system should be so designed so as to set up accounts in terms of areas of managerial responsibility. In other words, responsibility accounting is essential for successful budgetary control.

g)      Constant Vigilance: Reports comparing budget and actual results should be promptly prepared and special attention focused on significant exceptions i.e. figures that are significantly different from those expected.

h)      Maximum Profit: The ultimate object of realizing the maximum profit should always be kept uppermost.

i)        Cost of the System: The budget system should not cost more than it is worth. Since it is not practicable to calculate exactly what a budget system is worth, it only implies a caution against adding expensive refinements unless their value clearly justifies them.

j)        Integration with Standard Costing System: Where standard costing system is also used, it should be completely integrated with the budget programme, in respect of both budget preparation and variance analysis.

Difference Between Fixed Budget and Flexible Budget
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.
                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 the each of a number of alternative production levels or volumes.

Fixed Budget
Flexible Budget
It does not change with actual volume of activity achieved. Thus it is known as rigid or inflexible budget.
It can be recasted on the basis of activity level to be achieved. Thus it is not rigid.
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 levels of activity.
Here as all costs like - fixed, variable and semi-variable are related to only one level of activity. So variance analysis does not give useful information.
Here analysis of variance provides useful information as each cost is analysed according to its behaviour.

If the budgeted and actual activity levels differ significantly, then the aspects like cost ascertainment and price fixation do not give a correct picture.
Flexible budgeting at different levels of activity facilitates the ascertainment of cost, fixation of selling price and tendering of quotations.
Comparison of actual performance with budgeted targets will be meaningless specially when there is a difference between the two activity levels.
It provides a meaningful basis of comparison of the actual performance with the budgeted targets.