International financial and management accounting lesson 10

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UNIT IV LESSON 10 BUDGET AND BUDGETARY CONTROL CONTENTS 10.0 10.1 10.2 10.3 10.4 10.5 10.6 10.7 10.8 10.9 10.10 10.11 10.12 10.13 10.14 Aims and Objectives Introduction Functions of a Budget Essentials of Effective Budgeting 10.3.1 Research and Analysis 10.3.2 Sound Organisational Structure 10.3.3 Comparison with the Actual 10.3.4 Length of the Budget Period 10.3.5 The Budget Preparation Budgetary Controls 10.4.1 Budgetary Control and Responsibility Centres 10.4.2 Advantages of Budgeting and Budgetary Control Problems in Budgeting Characteristics of a Budget Budget Organisation and Administration 10.7.1 Budget Centres 10.7.2 Budget Committee 10.7.3 Budget Officer 10.7.4 Budget Manual The Budgetary Process Types of Budget 10.9.1 Master Budget 10.9.2 Functional Budgets Let us Sum up Lesson End Activity Keywords Questions for Discussion Suggested Readings 10.0 AIMS AND OBJECTIVES After studying this lesson, you will be able to: Understand meaning and functions of budget Describe the concept of budgetary control Discuss budgeting process Explain various types of budget 186 International Financial and Management Accounting 10.1 INTRODUCTION We are quite familiar with the word 'budget' in relation to economic policies of a national government Moreover, whenever we plan any activity, we generally make a 'budget' Similar is the case with any business activity A budget is a plan expressed in monetary terms covering a future time period Budgets are an important tool for management planning and control and are an integral part of a well-run business Budgets are based on a defined level of activity They are normally produced for a year which is divided into months/quarters, and are generally expressed either on the basis of expected sales revenue or capacity as the case may be Budgets may be recast anytime during a year, e.g., quarterly or six-monthly, usually to accommodate any changes/adjustments anticipated during a year At times confused with forecast, there is a distinction between the two A forecast usually refers to a prediction of economic activity based on data/information available, whereas a revised or budgetary update refers to revision of planned economic activity vis-à-vis resources available, typically covering a 12-month period Budget should not be confused with business targets, which are typically solely focused on achieving certain levels of activity, e.g., sales–budgets are primarily projection covering a gamut of activities linked to availability of external factors and internal inputs such as men, materials, machinery and money 10.2 FUNCTIONS OF A BUDGET Helps in allocation of resources for the implementation of the strategy Act as a tool to evaluate managerial performance Acts as a means to control activities Co-ordinate activities between different parts of the organisation 10.3 ESSENTIALS OF EFFECTIVE BUDGETING 10.3.1 Research and Analysis Budgets should be prepared keeping in view organisational goals Thorough research and analysis should be done of the various aspects related to growth and profitability of the organisation before forming budgets Properly conducted research helps in setting realistic goals for the budget which are in co-ordination with the overall organisational objectives 10.3.2 Sound Organisational Structure Well established authority–responsibility relationship at all levels for all phases of operation is important to build up a sound organisational structure Since a budget will be effective only if it is unanimously approved at all the levels of the organization, many organisations believe in a budget settlement process as a pre-requisite for getting overall approval/ acceptability Thus, while targets may be fixed arbitrarily, sound budgetary practices involve overall organisational consensus/commitment as a pre-requisite for successful implementation 10.3.3 Comparison with the Actual For the success of the budget it is important to systematically and periodically review the actual and expected results for any variations Reasons for the variations should be studied and analysised In this way budget become an important tool for evaluating performance Care should be taken that responsibility should be held only for variations which are controllable 10.3.4 Length of the Budget Period Factors influencing the length of the budget period are: the nature of the organisation, business conditions currently prevailing, the need for periodic appraisal etc A budget may be prepared for any period of time depending upon the requirement While setting budget period, due consideration should be given to minimise the impact of seasonal or cyclical fluctuations For example, cash budget is prepared monthly, whereas budget to buy a machinery worth Rs 10 crores may cover a six to eight year period In case of a long budget period it is difficult to determine reliable estimates, in view of various imponderables that will inevitably be encountered along the way For example, if global prices of oil shoot up by over 100%, entire national budgets/BOP positions will need recasting, what to speak of individual organisational budgets 10.3.5 The Budget Preparation The preparation of the budget is a lengthy process It begins with the collection of data several months before the end of the current year from within the organisation covering its various units Even the data related to the previous year's performance can be taken as a base for formulating future budgetary goals Other factors to be kept in mind are sales forecast, (the input of sales personnel and top management support are essential to the sales forecast), market research studies, changes in prices, general economic conditions, industry trends, technological developments etc In larger companies, budget committee is set up which is responsible for coordinating the preparation of the budget The budget committee includes management personnel looking after operation of major areas of, the company, such as sales, production, and research In small companies, the budgeting process is often informal 10.4 BUDGETARY CONTROLS A control technique whereby actual results are compared with budgets Any differences (variances) are made the responsibility of key individuals who can either exercise control action or revise the original budgets 10.4.1 Budgetary Control and Responsibility Centres These enable managers to monitor organisational functions A responsibility centre can be defined as any functional unit headed by a manager who is responsible for the activities of that unit There are four types of responsibility centres: a) Revenue centres: Organisational units in which outputs are measured in monetary terms but are not directly compared to input costs b) Expense centres: Units where inputs are measured in monetary terms but outputs are not c) Profit centres: Where performance is measured by the difference between revenues (outputs) and expenditure (inputs) Inter-departmental sales are often made using "transfer prices" 187 Budget and Budgetary Control 188 International Financial and Management Accounting d) Investment centres: Where outputs are compared with the assets employed in producing them, i.e ROI 10.4.2 Advantages of Budgeting and Budgetary Control There are a number of advantages to budgeting and budgetary control: Compels management to think about the future, which is probably the most important feature of a budgetary planning and control system Forces management to look ahead, to set out detailed plans for achieving the targets for each department, operation and (ideally) each manager, to anticipate and give the organisation purpose and direction Promotes coordination and communication Clearly defines areas of responsibility Requires managers of budget centres to be made responsible for the achievement of budget targets for the operations under their personal control Provides a basis for performance appraisal (variance analysis) A budget is basically a yardstick against which actual performance is measured and assessed Control is provided by comparisons of actual results against budget plan Departures from budget can then be investigated and the reasons for the differences can be divided into controllable and non-controllable factors Enables remedial action to be taken as variances emerge Motivates employees by participating in the setting of budgets Improves the allocation of scarce resources Economises management time by using the management by exception principle 10.5 PROBLEMS IN BUDGETING Whilst budgets may be an essential part of any marketing activity they have a number of disadvantages, particularly in perception terms Budgets can be seen as pressure devices imposed by management, thus resulting in: a) bad labour relations b) inaccurate record-keeping Departmental conflict arises due to: a) disputes over resource allocation b) departments blaming each other if targets are not attained It is difficult to reconcile personal/individual and corporate goals Waste may arise as managers adopt the view, "we had better spend it or we will lose it" This is often coupled with "empire building" in order to enhance the prestige of a department Responsibility versus controlling, i.e some costs are under the influence of more than one person, e.g power costs Managers may overestimate costs so that they will not be blamed in the future should they overspend 10.6 CHARACTERISTICS OF A BUDGET A good budget is characterised by the following: Participation: involve as many people as possible in drawing up a budget Comprehensiveness: embrace the whole organisation Standards: base it on established standards of performance Flexibility: allow for changing circumstances Feedback: constantly monitor performance Analysis of costs and revenues: this can be done on the basis of product lines, departments or cost centres 10.7 BUDGET ORGANISATION AND ADMINISTRATION In organising and administering a budget system the following characteristics may apply: 10.7.1 Budget Centres Units responsible for the preparation of budgets A budget centre may encompass several cost centres 10.7.2 Budget Committee This may consist of senior members of the organisation, e.g departmental heads and executives (with the managing director as chairman) Every part of the organisation should be represented on the committee, so there should be a representative from sales, production, marketing and so on Functions of the budget committee include: Coordination of the preparation of budgets, including the issue of a manual Issuing of timetables for preparation of budgets Provision of information to assist budget preparations Comparison of actual results with budget and investigation of variances 10.7.3 Budget Officer Controls the budget administration The job involves: liaising between the budget committee and managers responsible for budget preparation dealing with budgetary control problems ensuring that deadlines are met educating people about budgetary control 10.7.4 Budget Manual This document: charts the organisation details the budget procedures contains account codes for items of expenditure and revenue 189 Budget and Budgetary Control 190 timetables the process International Financial and Management Accounting clearly defines the responsibility of persons involved in the budgeting system 10.8 THE BUDGETARY PROCESS Budgets are based on standard costs for a defined level of sales demand or production activity for a defined period Generally, the budgeting process is as under: To identify business objectives and budget goals To forecast general business environment including economic and industry environment and the state of competition To develop detailed sales budgets by market sectors, geographic territories, major customers and product groups To prepare production budgets in respect of materials, labour and overhead by responsibility centre managers so that goods or services can be produced accordingly so as to satisfy the demand as per the sales forecast Preparation of non-production budgets by cost centres To prepare capital expenditure budgets To identify financing requirements by preparing cash forecasts To prepare master budget (profit and loss, balance sheet and cash flow/funds flow) To get approval of the board in respect of profitability and financing targets It is important to carry out a thorough investigation of current performance while preparing budget Besides this there are various factors which make the process of preparing budget complex Some of them are as follows: complete knowledge of past performance, i.e., a statistical and narratory database thorough knowledge and understanding of seasonal factors, market trends, competition etc in respect of the industry/business understanding the costs drivers whether or not the business is a price leader whether expenses are controllable or not It is imperative that a budget have subjective judgments of likely future events, customer demand and also assumptions about product/service mix, average prices, cost inflation etc Once the budget is approved in toto, the budget needs to be allocated, i.e., spread over each month This process of spreading the budget over a period of time is known as 'profiling' Profiling is either based on the number of working days, seasonal fluctuation or any other basis It helps in accurate estimation of the time period about the incurrence of the costs and the earning of the revenue as enshrined in the budgetary data The Budgetary Control Process The use of a budget to control a firm's activities is known as budgetary control The steps in budgetary control are as under: The establishment of budgets for each department Continuous monitoring of actual performance with the budgeted figures and fixing responsibilities Assessment / revision / corrective action in the light of changed circumstances or deviation in actual performance 10.9 TYPES OF BUDGET Budget may be classified as follows: 10.9.1 Master Budget A master budget is the summary budget for the entire enterprise and embodies the summarised figures for various activities It is the consolidation of all functional budgets A functional budget is a budget which relates to any of the functions of an undertaking, e.g., production, sales, finance, etc 10.9.2 Functional Budgets Principal functional budgets may be stated thus: (a) Sales budget: The sales budget is a forecast of total sales expressed in terms of money and quantity In practise, a quantitative budget is prepared first, then it is translated into monetary terms (b) Production budget: It is a forecast of the production for the budget period It may be expressed in units or standard hours A standard hour is the quantity of output or amount of work which should be performed in one hour While preparing the production budget, the production executive will take into account the physical facilities like plant, power, factory space, material, labour available for the period (c) Materials budget: It shows the details of raw materials to be consumed It is expressed in terms of physical quantities and values of materials to be issued from the stores for production purpose This budget provides that right materials of right quantity and quality are procured (d) Labour budget: It shows the details of labour requirements in quantity, with estimated costs This budget gives detailed information relating to the number of employees, rates of wages and cost of labour hours to be employed (e) Manufacturing overhead budget: It shows the estimated costs of indirect materials, indirect labour and indirect manufacturing expenses during the budget period to achieve the predetermined targets (f) Administration cost budget: This comprises of salaries and expenses of administrative office and management for a specified period It is prepared with the help of past experience and expected changes in future (g) Selling expenses budget: All expenses concerned with sale of products to customers are included in this budget It is generally prepared territory-wise by the sales manager of each territory, on the basis of past records (h) Research and development budget: This budget lists all the research and development activities together with their likely costs (i) Capital expenditure budget: This budget shows the estimated expenditure on fixed assets like plant, land, machinery, building etc It is a long-term budget The capital is necessitated on account of demand for products, expansion of industry, adoption of new technology, replacement of old machines, etc (j) Cash budget: It is prepared after all the functional budgets are prepared by the chief accountant either on a monthly or weekly basis It shows the sum total of the requirements of cash in respect of various functional budgets and of estimated cash receipts for a stipulated period 191 Budget and Budgetary Control 192 Check Your Progress International Financial and Management Accounting Define budget and Budgetary Control What you understand by ‘Master Budget’? 10.10 LET US SUM UP Budgets are useful in planning and control because they enhance co-ordination and communication It is an important tool for the purpose of the controlling because they provide a standard for evaluating performance As such they play a key role in evaluating individual as well as organisational performance, enabling timely corrective action/ counselling as the case may be Master budget is a comprehensive planning document and usually includes budgets for sales, production, direct material and labour, manufacturing overhead, selling and administrative overhead, capital acquisition, cash receipts and disbursement, a budgeted income statement and a balance sheet Static budget is not very useful for the purpose of comparison because if the actual level of production is different from the budgeted one, a comparison is not possible Flexible budgets are frequently used because they present amounts adjusted to the actual level of production Budgets are useful for the purpose of controlling, ensuring that managers can be held responsible for any deviation from the planned activity Care should be taken that the managers should be held responsible only for those deviations which are due to controllable factors 10.11 LESSON END ACTIVITY “Budgeting is an instrument of planning as well as a tool of managerial control.” Do you agree with the statement? Give reason for your answer 10.12 KEYWORDS Budget: A financial statement prepared for specified activity for future periods Budgeting: Activity of preparing the budget is known as budgeting Budgetary Control: Quantitative controlling technique to asses the performance of the organisation 10.13 QUESTIONS FOR DISCUSSION Describe the meaning and functions of budget Discuss the role of budgetary control as a cost control tool 3 What are the steps involved in budgeting process? Discuss the essentials of effective budgeting Check Your Progress: Model Answers Budget: A budget is a statement of planned allocation of resources expressed in financial or numerical terms Budgetary Control: It is a control technique whereby actual results are compared with budgets Master Budget: The master budget is a set of interrelated budgets that constitutes a plan of action for a specified time period It contains two classes of budget, i.e., operating budget and financial budget 10.14 SUGGESTED READINGS M.P Pandikumar, Management Accounting, Excel Books M N Arora, "Cost and Management Accounting", 8th Edition, Vikas Publishing House (P) Ltd Hilton, Maher and Selto, "Cost Management", 2nd Edition, Tata McGraw-Hill Publishing Company Ltd B.M Lall Nigam and I.C Jain, "Cost Accounting", Prentice-Hall of India (P) Ltd 193 Budget and Budgetary Control .. .LESSON 10 BUDGET AND BUDGETARY CONTROL CONTENTS 10. 0 10. 1 10. 2 10. 3 10. 4 10. 5 10. 6 10. 7 10. 8 10. 9 10. 10 10. 11 10. 12 10. 13 10. 14 Aims and Objectives Introduction Functions... budget, i.e., operating budget and financial budget 10. 14 SUGGESTED READINGS M.P Pandikumar, Management Accounting, Excel Books M N Arora, "Cost and Management Accounting" , 8th Edition, Vikas... budgets and of estimated cash receipts for a stipulated period 191 Budget and Budgetary Control 192 Check Your Progress International Financial and Management Accounting Define budget and Budgetary
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