Year: 2020

Sources of Risk:

There are a variety of situations that give rise to risk.

1. Decision/Indecision:

Taking or not taking a decision at the right time is generally the first cause of risk. Suppose a banker takes deposits and decides not to put money in statutory liquidity requirements, the bank would be called upon to pay penalties. Indecision in selling a Government security when the market is upswing is also a risk as it causes loss of revenue. The risk of revenue loss is on account of indecision.

2. Business Cycles/Seasonality:

There are certain exposures that are affected by seasonality or business cycles. Lending to sugar industry in India disregarding the fact that the production of sugar is restricted to six/seven months in a year, may give rise to risky situations.

3. Economic/Fiscal Changes:

The Government’s economic and taxation policies are sources of risk. The levying of import duty on certain capital goods can escalate the funding cost and bank finance requirement. While the borrower’s repay­ing capacity remains the same, such a situation enhances the exposure adding to the risk. The changes in Government policies can impact the cash inflow for the borrowing cus­tomer thereby limiting his repayment capacity.

4. Market Preferences:

Over the years, the consumer demands and preferences particularly from the youth segment, are changing substantially. The preference for a motorcycle over a scooter is an example. Lending to scooter dealers or manufacturers will have to be cautious due to this market trend.

5. Political Compulsions:

A Government may force the banks to lend in areas where the rewards may not be proportional.

6. Regulations:

The impact of change in regulations is similar to the changes in Government policies. In developed countries like the USA, there are certain anti- boycott laws prescribing restrictions. The anti-boycott laws specifically refer to boy­cotts involving one foreign Government against another foreign Government and participation of people in the US in those boycotts.

Indian banks operating in the USA do have to assess the regulatory risks. With the passing of USA Patriot Act, the processes for anti-money laundering have been strengthened. Compliance of a variety of regulations is also a source of risk.

7. Competition:

In order to remain competitive banks assume risks for enhancing the returns. In the quest to achieve better result there could be a tendency to assume risks highly unrelated to the return. The selection of the right counter party, lack of proper risk assessment, failure to appreciate the borrower rating, etc., all contribute in risk acceleration. Competition remains a major source of risk for banks as for all other sectors.

8. Technology:

Technology is both, a solution and a cause of risk. Deals worth millions are made in treasury operations through advanced technology supports. The process of maker-checker is scrupulously followed while entering into such deals. Still, machines can go wrong. The reflection of inaccurate values like dates, amounts, interest rates, etc., can cause a huge risk. It is a part of operational risk wherein technology itself becomes the source of risk.

9. Non-availability of Information:

Technology is an enabler for decision support for rational and data-based decision mak­ing. More often than not, in the absence of information support, banks do take decisions. The banks fix exposure limits per party or per industry. Exposures exceed these prudential limits in the absence of real time information, thereby multiplying the risk exposures.

In reality, the risk drivers are:

1. Changes in external environment, including regulatory as­pects,
2. Deficiencies in systems and procedures,
3. Errors, either intentional or otherwise,
4. Inadequate information and absence of required flows,
5. Unsuitable technology supports,
6. Communication gap or failure,
7. Lack of leadership, and 
8. Excessive and unreasonable incentives.

Indicators of Risk:

Risks very rarely occur as accidents. There are symptoms that indicate the possibility of risk. These indicators can be used to take pre-emptive actions. These actions may not eliminate the risks, but they would at least facilitate to minimize their impact.

1. Lack of supervision of lending/investment activities by designated officers.
2. Lack of specific lending or treasury policies or failure to enforce the existing policies.
3. Lack of code of conduct or failure to enforce existing code.
4. Dominant figure allowed to exerting influence without re­straint.
5. Lack of separation of duties.
6. Lack of accountability.
7. Lack of written policies and/or internal controls.
8. Circumvention of established policies and/or controls.
9. Lack of independent members of management and / or Board.
10. Entering into transactions where the institution lacks exper­tise.
11. Excessive growth through low quality loans.
12. Unwarranted concentrations.
13. Volatile sources of funding such as short-term deposits from out of area brokers.
14. Too much emphasis on earnings at the expense of safety and soundness.
15. Compromising credit policies.
16. High rate high risk investments.
17. Underwriting criteria allowing high risk loans.
18. Lack of documentation or poor documentation.
19. Lack of adequate credit analysis.
20. Failure to properly obtain and evaluate credit data, collat­eral, etc.
21. Failure to properly analyze and verify financial statement data.
22. Too much emphasis on character and collateral and not enough emphasis on credit.
23. Lack of proper mix in asset portfolio.
24. Unresolved exceptions or frequently recurring exceptions on exception reports.
25. Out of balance conditions.
26. Funds used for purposes other than the purpose recorded.
27. Lax policies on payment of checks against uncollected funds.
28. The institution is a defendant in a number of lawsuits alleging improper handling of transactions.

Pure Risk

There are only two possibilities; something bad happening or nothing happening. It is unlikely that any measurable benefit will arise from a pure risk. The house will enjoy a year with nothing bad occurring or there will be damage caused by a covered cause of loss (fire, wind, etc.). Predicting the outcomes of a pure risk is accomplished (sometimes) using the law of large numbers, a prior data or empirical data. Pure risk, also known as absolute risk, is insurable.

Pure risk is a type of risk that cannot be controlled and has two outcomes: complete loss or no loss at all. There are no opportunities for gain or profit when pure risk is involved.

Pure risk is generally prevalent in situations such as natural disasters, fires, or death. These situations cannot be predicted and are beyond anyone’s control. Pure risk is also referred to as absolute risk.

Pure risk examples

Personal risks affect individuals and involve losing or reducing personal assets. For example, unemployment is a pure risk resulting in financial loss when income and benefits are taken away. There are numerous other types of personal, pure risks, however: Poor health runs the risk of large medical bills, and the risk of an unforeseen, permanent disability could end a person’s career and, as a result, dramatically reduce their income. The pure risk of premature death also impacts the deceased family members who might struggle to pay household bills if the breadwinner unexpectedly dies.

Pure risk to property includes fires, wind damage, flooding and other natural disasters that cause damage to personal belongings.

Liability risks are also considered pure risks and pertain to potential litigation against a person or organization. For example, a homeowner could be sued by a person who slipped on their walkway for medical expenses, lost income or other damages.

Types of Pure Risk

Personal risks directly affect an individual and may involve the loss of earnings and assets or an increase in expenses. For example, unemployment may create financial burdens from the loss of income and employment benefits. Identity theft may result in damaged credit, and poor health may result in substantial medical bills, as well as the loss of earning power and the depletion of savings.

Property risks involve property damaged due to uncontrollable forces such as fire, lightning, hurricanes, tornados, or hail.

Liability risks may involve litigation due to real or perceived injustice. For example, a person injured after slipping on someone else’s icy driveway may sue for medical expenses, lost income, and other associated damages.

Insuring Against Pure Risk

Unlike most speculative risks, pure risks are typically insurable through commercial, personal, or liability insurance policies. Individuals transfer part of a pure risk to an insurer. For example, homeowners purchase home insurance to protect against perils that cause damage or loss. The insurer now shares the potential risk with the homeowner.

Pure risks are insurable partly because the law of large numbers applies more readily than to speculative risk. Insurers are more capable of predicting loss figures in advance and will not extend themselves into a market if they see it as unprofitable.

Speculative Risk

Unlike pure risk, speculative risk has opportunities for loss or gain and requires the consideration of all potential risks before choosing an action. For example, investors purchase securities believing they will increase in value.

But the opportunity for loss is always present. Businesses venture into new markets, purchase new equipment, and diversify existing product lines because they recognize the potential gain surpasses the potential loss.

Speculative risk is a category of risk that, when undertaken, results in an uncertain degree of gain or loss. All speculative risks are made as conscious choices and are not just a result of uncontrollable circumstances. Since there is some chance of either a gain or a loss, speculative risk is the opposite of pure risk, which is the possibility of only a loss and no potential for gain.

Almost all investment activities involve some speculative risks, as an investor has no idea whether an investment will be a blazing success or an utter failure. Some assets such as an options contract carry a combination of speculative risk and risk that you can hedge.

Some investments are more speculative than others. For example, investing in government bonds has much less speculative risk than investing in junk bonds because government bonds have a much lower risk of default. In many cases, the greater the speculative risk, the higher the potential for profits or returns on the investment.

Examples of Speculative Risk

Most financial investments, such as the purchase of stock, involve speculative risk. It is possible for the share value to go up, resulting in a gain, or go down, resulting in a loss. While data may allow certain assumptions to be made regarding the likelihood of a particular outcome, the outcome is not guaranteed.

Sports betting also qualifies as having speculative risk. If a person is betting on which team will win a football game, the outcome could result in a gain or loss, depending on which team wins. While the outcome cannot be known ahead of time, it is known that a gain or loss are both possible.

If you buy a call option, you know in advance that your maximum downside risk is the loss of the premium paid if the options contract expires worthless. At the same time, you do not know what your potential upside gain will be since nobody can know the future.

On the other hand, selling or writing a call option carries unlimited risk in exchange for the premium collected. However, some of that speculative risk can be hedged with other strategies, such as owning shares of the stock or by purchasing a call option with higher strike price. In the end, the amount of speculative risk will depend on whether the option is bought or sold and whether it is hedged or not.

Pure vs. speculative risk

While pure risk is beyond human control and can only result in a loss if it occurs, speculative risk is taken on voluntarily and can result in either a profit or loss. Speculative risks are undertaken through a conscious choice, and they are considered a controllable risk. Almost all financial investment activities, for example, are considered speculative risk because they ultimately result in an unknown amount of success or failure.

Betting on sports is also considered a speculative, controllable risk. A person betting on an NFL game could see either a financial gain or financial loss from the bet, depending on which team wins. Unlike pure risk that will only result in a loss, betting on the game could result in either a gain or a loss for the person undertaking the bet, or in this case, the risk.

Risk assessment is one method in a much broader field of risk management. Risk assessment is a process that does not result in a fixed final answer. It is impossible to determine the true magnitude and extent of any actual contamination at a site.

Advantages or Benefits of Risk Management Process

Risk management process is considered as an important discipline that the business has in its recent times.

Many organizations tend to realize the advantages of enterprise risk management. Following are a few benefits of risk management in projects:

1. Benefits of risk identification

Risk identification helps in fostering the vigilance in times of discipline and calm at the times of crisis. It implies all the risks in prior that are most likely to happen and are planned to execute without any assumptions that run.

These positive risks are often held upon most of the occurrences. It helps in opportunity risks so as to be aware of the forthcoming issues.

2. Benefits of risk assessment

It focuses on the identified tasks on assisting the impact of business or projects. This phase focuses on the ideas that are discussed among the stakeholders. It has the greatest advantage of dealing with the points that are finalized with more possible solutions.

It has a sense of all views that turns into accountability of each and every social life. Participation in these kinds of assessments will help one to tackle his/her risks. It promotes organizational culture.

3. Treatment of risks

It helps in treating one’s own risks that are the subsets of implementing a plan. It has internal compliance that is brought and mitigated towards the forsaken actions.

Its opportunity falls in the lack of preparation and even more realized upon the profitable data that relieves through internal controls.

4. Minimization of risks

The risks that are handled within the given assessments plans are foreseen within the business functions. It enables one to speed up the data to change policies and contingencies that are made successful within the mapped business functions.

Here the cost-beneficial analysis is to be revised within the ownership of risks. It focuses on the change of policies within the detailed structural behavior.

5. Awareness about the risks

Here the terms that are noticed will create awareness among the scheduled terms of risks that are a successful analysis and evaluation of exercising the modules of risks.

It enables one to concentrate on the risk treatments within the lessons learned and are scheduled into lack of preparation. It has subsequent phases regarding each module within the identified data.

6. Successful business strategies

Risk management strategy is not a one-time activity and the grade points are finalized within the recent status. It has different stages that modulate to lack of preparation, planning and successful implementations of all the plans.

It has the operational efficiency that is realized upon the mitigation of negative risks. It has contingent policies over the preparation of business in the measures of treatment.

7. Saving cost and time

It threats to the task that is completed over the projects and the other business strategies.

It always results in saving the costs that are consolidated within the items that are practiced. It prevents wastage and makeup time for firefighting.

8. New opportunities

The opportunities that are emerging are held within the new ways of communicating on the unravel issues.

It has a collective and least significant part that matches with most of the scenarios. It prepares for future endeavors and the related exhaustive efforts as inputs.

9. Harvesting knowledge

Here one must try to spend the knowledge about the stakeholder’s experience of the preemptive approach that is made applicable for the unprepared threats towards the knowledge gained and this provides a template to face the readymade risks.

It has successive plans that are indulged from the start till the collective knowledge.

10. Protecting resources

The risk management plans and policies under help in protecting the resources of the organization. This helps in promoting the resources instead of using them illegally.

It also equips safety among the adaptive changes to the staff alternatives and is bundled together with the other resources. It builds production plans and alternative plans for the process of re-routing.

11. Improvement in credit ratings

The improvement in credit ratings evolves numerous agencies that support the accomplished tasks resulting in lower budget investments.

It has capital volatility that translates the greater confidence issues, particularly with the stakeholders. It aims at building multiple business aspects that have tangible benefits.

12. Regulatory compliances

This framework helps in meeting regulatory needs. It performs and measures risk management. This improvement helps in attaining higher credit aspects.

It also derives higher efficiency towards the capital volatility and even the rating metrics that are assigned to the compensated business plans. It translates into greater confidence of improved stakeholders that are made applicable within the insured business.

13. Values shareholders

It aims at the borrowing capacity of the shareholder that has significant effort within the management and assumes the determinant roles that the company can extend to.

It has the exact decision-making process within the current models and also the expected regulatory recruitment.

14. Possibilities of risks

It dictates the clear possibilities of risk that are managed within the severity or impact of the organization that is updated to own risk strategies. It has an insight of real balance sheets that supports the culture of risk management.

It modulates the designed data and even the approach towards the compatible and the insight of balancing. It supports all the ordinary requirements of a plan.

15. Faster competition

When the organization contributes to different levels of budgets with the people of various skills set, the commitment towards the work will be more.

It achieves competitive advantage on the logic schedules that are better. It has the deepest level of managing risks. These competitions are managed within the up and downs of an entire life.

16. Provides support

It provides support to the organization that is handled between both the chances of achieving and losing the financial plans.

Here the benefits of financial risk management are uninformed at both the level of improving chances to make the acquisition of achieving a potential breakthrough in the supply chain. It has concentrated support of the chances of achieving the pre-planned financial activities.

17. Identification of risks

A risk management system helps in identifying the risks that have a precise network to determine the optimal management of risks. It has the maximized opportunity of the risks that are relevant in implementing the guidance provided.

It has holistic support from the entire organization when the risks are identified. It will become streamlined and efficient within the complex elements.

18. Provides guidance

It provides prior guidance about the framework that is enabled within the experience and assessing the risks that are modeled within the strategies of risk.

It has the development of advanced risk management techniques that are interrelated within the consequences of the gained knowledge and the other risks.

19. Identification of possible threats

This identification provides compensatory mundane activities that aim at motivating the employees to gather information about the consequent changes.

It spends time on the research and development of the execution of maintenance strategies. It accustoms the employees within the persuaded timing.

20. Reduces impact and loss

Risk management has more defined proceedings when there is a pre-planned schedule or loss of the object. It contributes a part to stress and worry. The complexity matters when they are gathered.

Here it ensures the organization with all possible outcomes of the independent and objective assessments that are analyzed on taking challenges.

21. Stability of earnings

The business operations that are held within the next operation level will concentrate more on the scheduled amount of data.

It reduces the impact of business activities. Employees will be retrenched so as to keep in the comfort zone.

22. Managing strategic plans

Managing risks has the strategic plans that are related to the plans that are most used in various strategic plans. This manages the data that depends on most of the resources that are linked to the migration defined data.

It reflects on the generated data that manages most of the generated cash flows that are in adverse situations.

23. Handling previous projects

If the analyzing of risk is done correctly in the previous stages, then it can be moved without processing the detailed information along various channels of risks. This memory can be held to unfold the future risks that are conflicted within the schematic schedule.

It enlarges new risk towards the competitors that are managed within the forbidden strategies.

24. Nurturing risks

Each possibility of the risks will be accompanied by the different logics that can compensate within the rigid comparisons and the choices made defining the aligned decision-makers of each project. This requires well-trained operators so as to optimize the situations of risks.

25. Collaborated work

Risks focus payoff and even to yield the profit. Sometimes the mistakes done can also be productive. It manages the possibility to perform tasks with organizational behavior.

Here managers are encouraged to focus on the risks that can be defined as exploitable challenging proposals.

Disadvantages of Risk Management Process

Managing the risks provides the waste of time to compensate for the projects. It persuades the projects that reciprocate to improve the funds in the company. It is spent on the research and development of the allocated issues that hold to ensure project management.

1. Complex calculations

Risk management involves complex calculations in terms of managing risks. Without the automatic tool, each and every calculation regarding risks becomes difficult.

2. Unmanaged losses

If the organization meddles with a loss, then that pay will be delivered to the pay loss of the firm.

Here, the organization is responsible for the loss that happened due to improper schedule about risk management.

3. Ambiguity

Even if the ambiguity is out of loss then people have to cover it within the planned scale of losses of the discounts and even the consideration into unnecessary insurance discounts.

4. Depends on external entities

Managing risks depends on the external entities that are modulated within the organization, usually depends on the external data.

It includes all the dependent information about the risks regarding other valid resources. The transferable resources depend on the external entities that tend to have data.

5. Mitigation

Usually, mitigation guarantees losses of the concealed impairment of money which may cause improper management of risks. This leads to unsafe acceptance of data within rare company losses.

6. Difficulty in implementing

Risk management takes a long time to gather information regarding strategic plans. It has universal standards that are mitigated and accepted according to the monetary values.

It matches with a hard understanding without recent experience without compensation of the required quantity of data.

7. Performance

Since the risk management can be processed only with subjectivity, it holds on the control of prospects within each issue. It can be identified with the difficult implementation of controls.

It manages the cost-benefits analysis that is not implemented. This process concentrates more on the implementation of controls.

8. Potential threats

These potential threats are to be maintained carefully so as to organize and disappear from the market. This implementation reduces the level of risk and proportionally increases the control over it.

Any kind of process will have its own limitations and benefits of project risk management. Thus to build an effective risk management one has to focus on the mitigated strategic plans of risks that are effective on the risk-takers. It is to identify the maximum of the entire management to overcome forthcoming dangers.

Risk management becomes the major case when the organization has targeted results apart from potential threats, damages, and vulnerabilities.

Risk Management is the process of identifying, assessing, and controlling threats to an organization’s capital and earnings. These threats, or risks, could stem from a wide variety of sources, including financial uncertainty, legal liabilities, strategic management errors, accidents, and natural disasters. IT security threats and data-related risks, and the risk management strategies to alleviate them, have become a top priority for digitized companies. As a result, a risk management plan increasingly includes companies’ processes for identifying and controlling threats to its digital assets, including proprietary corporate data, a customer’s personally identifiable information (PII) and intellectual property.

All risk management processes follow the same basic steps, although sometimes different jargon is used to describe these steps. Together these 5 risk management process steps combine to deliver a simple and effective risk management process.

Step 1

Identify the Risk. You and your team uncover, recognize and describe risks that might affect your project or its outcomes. There are a number of techniques you can use to find project risks. During this step you start to prepare your Project Risk Register.

Step 2

Analyze the risk. Once risks are identified you determine the likelihood and consequence of each risk. You develop an understanding of the nature of the risk and its potential to affect project goals and objectives. This information is also input to your Project Risk Register.

Step 3

Evaluate or Rank the Risk. You evaluate or rank the risk by determining the risk magnitude, which is the combination of likelihood and consequence. You make decisions about whether the risk is acceptable or whether it is serious enough to warrant treatment. These risk rankings are also added to your Project Risk Register.

Step 4

Treat the Risk. This is also referred to as Risk Response Planning. During this step you assess your highest ranked risks and set out a plan to treat or modify these risks to achieve acceptable risk levels. How can you minimize the probability of the negative risks as well as enhancing the opportunities? You create risk mitigation strategies, preventive plans and contingency plans in this step. And you add the risk treatment measures for the highest ranking or most serious risks to your Project Risk Register.

Step 5

Monitor and Review the risk. This is the step where you take your Project Risk Register and use it to monitor, track and review risks.

Risk is about uncertainty. If you put a framework around that uncertainty, then you effectively de-risk your project. And that means you can move much more confidently to achieve your project goals. By identifying and managing a comprehensive list of project risks, unpleasant surprises and barriers can be reduced and golden opportunities discovered. The risk management process also helps to resolve problems when they occur, because those problems have been envisaged, and plans to treat them have already been developed and agreed. You avoid impulsive reactions and going into “fire-fighting” mode to rectify problems that could have been anticipated. This makes for happier, less stressed project teams and stakeholders. The end result is that you minimize the impacts of project threats and capture the opportunities that occur.

Preventable Risks

These are internal risks, arising from within the organization, that are controllable and ought to be eliminated or avoided. Examples are the risks from employees’ and managers’ unauthorized, illegal, unethical, incorrect, or inappropriate actions and the risks from breakdowns in routine operational processes. To be sure, companies should have a zone of tolerance for defects or errors that would not cause severe damage to the enterprise and for which achieving complete avoidance would be too costly. But in general, companies should seek to eliminate these risks since they get no strategic benefits from taking them on. A rogue trader or an employee bribing a local official may produce some short-term profits for the firm, but over time such actions will diminish the company’s value.

This risk category is best managed through active prevention: monitoring operational processes and guiding people’s behaviors and decisions toward desired norms. Since considerable literature already exists on the rules-based compliance approach, we refer interested readers to the sidebar “Identifying and Managing Preventable Risks” in lieu of a full discussion of best practices here.

Strategy Risks

A company voluntarily accepts some risk in order to generate superior returns from its strategy. A bank assumes credit risk, for example, when it lends money; many companies take on risks through their research and development activities.

Strategy risks are quite different from preventable risks because they are not inherently undesirable. A strategy with high expected returns generally requires the company to take on significant risks, and managing those risks is a key driver in capturing the potential gains. BP accepted the high risks of drilling several miles below the surface of the Gulf of Mexico because of the high value of the oil and gas it hoped to extract.

Strategy risks cannot be managed through a rules-based control model. Instead, you need a risk-management system designed to reduce the probability that the assumed risks actually materialize and to improve the company’s ability to manage or contain the risk events should they occur. Such a system would not stop companies from undertaking risky ventures; to the contrary, it would enable companies to take on higher-risk, higher-reward ventures than could competitors with less effective risk management.

External Risks

Some risks arise from events outside the company and are beyond its influence or control. Sources of these risks include natural and political disasters and major macroeconomic shifts. External risks require yet another approach. Because companies cannot prevent such events from occurring, their management must focus on identification (they tend to be obvious in hindsight) and mitigation of their impact.

Companies should tailor their risk-management processes to these different categories. While a compliance-based approach is effective for managing preventable risks, it is wholly inadequate for strategy risks or external risks, which require a fundamentally different approach based on open and explicit risk discussions. That, however, is easier said than done; extensive behavioral and organizational research has shown that individuals have strong cognitive biases that discourage them from thinking about and discussing risk until it’s too late.

Classification of Risks in Banking sector

     

1. Credit Risk

• Credit risks involve borrower risk, industry risk and portfolio risk. As it checks the creditworthiness of the industry, borrower etc.
• It is also known as default risk which checks the inability of an industry, counter-party or a customer who are unable to meet the commitments of making settlement of financial transactions.
• Internal and external factors both influences credit risk of bank portfolio.
• Internal factors consist of lack of appraisal of borrower’s financial status, inadequate risk pricing, lending limits are not defined properly, absence of post sanctions surveillance, proper loan agreements or policies are not defined etc.
• Whereas external factor comprises of trade restrictions, fluctuation in exchange rates and interest rates, fluctuations in commodities or equity prices, tax structure, government policies, political system etc.

How banks manage this risk?

• Top management consent or attention should be received in order to manage the credit risk.
• Credit Risk Management Process include:

1. In a loan policy of banks, risk management process should be articulated.
2. Through credit rating or scoring the degree of risk can be measured.
3. It can be quantified through estimating expected and unexpected financial losses and even risk pricing can be done on scientific basic.

• Credit Policy Committee should be formed in each bank that can look after the credit policies, procedures and agreements and thus can analyze, evaluate and manage the credit risk of a bank on a wide basis.
• Credit Risk Management consists of many management techniques which helps the bank to curb the adverse effect of credit risk. Techniques includes: credit approving authority, risk rating, prudential limits, loan review mechanism, risk pricing, portfolio management etc.

2.  Market Risk 

• Earlier, majorly for all the banks managing credit risk was the primary task or challenge.
• But due to the modernization and progress in banking sector, market risk started arising such as fluctuation in interest rates, changes in market variables, fluctuation in commodity prices or equity prices and even fluctuation in foreign exchange rates etc.
• So, it became essential to manage the market risk too. As even a minute change in market variables results into substantial change of economic value of banks.
• Market risk comprises of liquidity risk, interest rate risk, foreign exchange rate risk and hedging risk.

How banks manage this risk?

• The major concern for the top management of banks is to manage the market risk.
• Top management of banks should clearly articulate the market risk policies, agreements, review mechanisms, auditing & reporting systems etc. and these policies should clearly mention the risk measurement systems which captures the sources of materials from banks and thus has an effect on banks.
• Banks should form Asset-Liability Management Committee whose main task is to maintain & manage the balance sheet within the risk or performance parameters.
• In order to track the market risk on a real time basis, banks should set up an independent middle office.
• Middle office should consist of members who are market experts in analyzing the market risk. The experts can be: economists, statisticians and general bankers.
• The members of Middle office should be separated from treasury departments or in daily activities of treasury department.

3. Operational Risk

• For a better risk management practice, it has become essential to manage the operational risk.
• Operational risk arise due to the modernization of banking sector and financial markets which gave rise to structural changes, increase in volume of transactions and complex support systems.
• Operational risk cannot be categorized as market risk or credit risk as this risk can be described as risk related to settlement of payments, interruption in business activities, legal and administrative risk.
• As operational risk involves risk related to business interruption or problem so this could trigger the market or credit risks. Therefore, operational risk has some sort of linkages with credit or market risks.

How banks manage this risk?

• There is no uniform approach in measuring the operational risk of banks. Till date simple and experimental methods are used but foreign banks have introduced some advance techniques to manage the operational risk.
• For measuring operational risk, it requires estimation of the probability of operational loss and also potential size of the loss.
• Banks can make use of analytical and judgmental techniques to measure operational risk level.
• Risk of operations can be: audit ratings, data on quality, historical loss experience, data on turnover or volume etc. Some international banks has developed rating matrix which is similar to bond credit rating.
• Operational risk should be assessed & reviewed at regular intervals.
• For quantifying operational risk, Indian banks have not evolved any scientific methods and are using simple benchmark system which measures business activity.

Risk is the chance of loss, and peril is the direct cause of the loss. If a house burns down, then fire is the peril. A hazard is anything that either causes or increases the likelihood of a loss. For instance, gas furnaces are a hazard for carbon monoxide poisoning. A physical hazard is a physical condition that increases the possibility of a loss. Thus, smoking is a physical hazard that increases the likelihood of a house fire and illness.

Moral hazards are losses that results from dishonesty. Thus, insurance companies suffer losses because of fraudulent or inflated claims. The legal system is a moral hazard in that it motivates many people to sue simply for financial profit because of the enormous amount of money that can sometimes be won, and because there is little cost to the plaintiff, even if he loses. A good example is the current asbestos litigation, which has bankrupted many companies, even though very few plaintiffs show any real evidence of disease, and are unlikely to ever develop any disease that can be shown, by the preponderance of the evidence, to have resulted from asbestos exposure. This type of moral hazard is often referred to as legal hazard. Legal hazard can also result from laws or regulations that force insurance companies to cover risks that they would otherwise not cover, such as including coverage for alcoholism in health insurance.

Insurance can be regarded as a morale hazard because it increases the possibility of a loss that results from the insured worrying less about losses. Therefore, they take fewer precautions and may engage in riskier activities because they have insurance. A good example of morale hazard is when the federal government bails out financial institutions who have made bad decisions. Many financial institutions have taken significant risks in the recent subprime debacle by buying toxic instruments, such as CDOs and mortgage-backed securities based on subprime mortgages that paid high yields, but were extremely risky. The financial institutions have considered themselves too big to fail in other words, if things started going badly, then the federal government would step in to stop their collapse for fear that the whole financial system will collapse, which is exactly what the federal government did in September, 2008. Freddie Mac and Fannie Mae have both been taken over by the government, and American International Group (AIG) has been propped up by an infusion of $85 billion of taxpayers’ money. AIG sold credit default swaps on mortgage-backed securities to buyers, mostly banks, thinking that they could collect the premiums, but would never have to actually to pay for defaults but if they were wrong, then the government would save them, because otherwise the banks that had bought that credit default protection could also possibly fail. As recent events have demonstrated all too clearly, this federal government “insurance” creates a morale hazard for financial institutions taxpayers pay the premium, but the big financial institutions, with their overpaid CEOs and managers, receive the benefits.

Risk management encompasses the identification, analysis, and response to risk factors that form part of the life of a business. Effective risk management means attempting to control, as much as possible, future outcomes by acting proactively rather than reactively. Therefore, effective risk management offers the potential to reduce both the possibility of a risk occurring and its potential impact.

Risks Management Structures

Risk management structures are tailored to do more than just point out existing risks. A good risk management structure should also calculate the uncertainties and predict their influence on a business. Consequently, the result is a choice between accepting risks or rejecting them. Acceptance or rejection of risks is dependent on the tolerance levels that a business has already defined for itself.

Risk Management in Indian banks is a relatively newer practice but has already shown to increase efficiency in governing of these banks as such procedures tend to increase the corporate governance of a financial institution. In times of volatility and fluctuations in the market, financial institutions need to prove their mettle by withstanding the market variations and achieve sustainability in terms of growth and well as have a stable share value. Hence, an essential component of risk management framework would be to mitigate all the risks and rewards of the products and service offered by the bank. Thus, the need for an efficient risk management framework is paramount to factor in internal and external risks.

Total Impact of Risk

Total impact of the risk (TIR) occurring would entail as the impact (I), the risk would cause multiplied by the Risk Ratio. It is essentially how much a bank would be impacted in the chance that the risk did occur. This essentially helps ascertain what is the total value of their investments that may be subject to risk and how it would impact them.

TIR = I × RR

Types of Risk

Types of Risks in Banking

The term Risk and the types associated to it would refer to mean financial risk or uncertainty of financial loss. The Reserve Bank of India guidelines issued in Oct. 1999 has identified and categorized the majority of risk into three major categories assumed to be encountered by banks. These belong to the clusters:

• Credit risk
• Market risk
• Operational risk

The type of risks can be fundamentally subdivided in primarily of two types, i.e. Financial and Non-Financial Risk. Financial risks would involve all those aspects which deal mainly with financial aspects of the bank. These can be further subdivided into Credit Risk and Market Risk. Both Credit and Market Risk may be further subdivided.

Non-Financial risks would entail all the risk faced by the bank in its regular workings, i.e. Operational risk, Strategic risk, Funding risk, Political risk, and Legal risk.

If a business sets up risk management as a disciplined and continuous process for the purpose of identifying and resolving risks, then the risk management structures can be used to support other risk mitigation systems. They include planning, organization, cost control, and budgeting. In such a case, the business will not usually experience many surprises, because the focus is on proactive risk management.

Response to Risks

Response to risks usually takes one of the following forms:

• Avoidance: A business strives to eliminate a particular risk by getting rid of its cause.
• Mitigation: Decreasing the projected financial value associated with a risk by lowering the possibility of the occurrence of the risk.
• Acceptance: In some cases, a business may be forced to accept a risk. This option is possible if a business entity develops contingencies to mitigate the impact of the risk, should it occur.

When creating contingencies, a business needs to engage in a problem-solving approach. The result is a well-detailed plan that can be executed as soon as the need arises. Such a plan will enable a business organization to handle barriers or blockage to its success, because it can deal with risks as soon as they arise.

Importance of Risk Management

Risks management is an important process because it empowers a business with the necessary tools so that it can adequately identify and deal with potential risks. Once a risk’s been identified, it is then easy to mitigate it. In addition, risk management provides a business with a basis upon which it can undertake sound decision-making.

For a business, assessment and management of risks is the best way to prepare for eventualities that may come in the way of progress and growth. When a business evaluates its plan for handling potential threats and then develops structures to address them, it improves its odds of becoming a successful entity.

In addition, progressive risk management ensures risks of a high priority are dealt with as aggressively as possible. Moreover, the management will have the necessary information that they can use to make informed decisions and ensure that the business remains profitable.

Other important benefits of risk management include:

• Creates a safe and secure work environment for all staff and customers.
• Increases the stability of business operations while also decreasing legal liability.
• Provides protection from events that are detrimental to both the company and the environment.
• Protects all involved people and assets from potential harm.
• Helps establish the organization’s insurance needs in order to save on unnecessary premiums.

The importance of combining risk management with patient safety has also been revealed. In most hospitals and organizations, the risk management and patient safety departments are separated; they incorporate different leadership, goals and scope. However, some hospitals are recognizing that the ability to provide safe, high-quality patient care is necessary to the protection of financial assets and, as a result, should be incorporated with risk management.

Risk Analysis Process

Risks analysis is a qualitative problem-solving approach that uses various tools of assessment to work out and rank risks for the purpose of assessing and resolving them. Here is the risk analysis process:

1. Identify existing risks

Risk identification mainly involves brainstorming. A business gathers its employees together so that they can review all the various sources of risk. The next step is to arrange all the identified risks in order of priority. Because it is not possible to mitigate all existing risks, prioritization ensures that those risks that can affect a business significantly are dealt with more urgently.

2. Assess the risks

In many cases, problem resolution involves identifying the problem and then finding an appropriate solution. However, prior to figuring out how best to handle risks, a business should locate the cause of the risks by asking the question, “What caused such a risk and how could it influence the business?”

3. Develop an appropriate response

Once a business entity is set on assessing likely remedies to mitigate identified risks and prevent their recurrence, it needs to ask the following questions: What measures can be taken to prevent the identified risk from recurring? In addition, what is the best thing to do if it does recur?

4. Develop preventive mechanisms for identified risks

Here, the ideas that were found to be useful in mitigating risks are developed into a number of tasks and then into contingency plans that can be deployed in the future. If risks occur, the plans can be put to action.

Conclusion

Our business ventures encounter many risks that can affect their survival and growth. As a result, it is important to understand the basic principles of risk management and how it can be used to help mitigate the effects of risks on business entities.

Marginal costing is a principle whereby variable costs are charged to cost units and the fixed costs attributable to the relevant period is written off in full against the contribution for that period.

Marginal costing is the ascertainment of marginal cost and the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable cost. In marginal costing, costs are classified into fixed and variable costs.

The concept of marginal costing is based on the behaviour of costs that vary with the volume of output. Marginal costing is known as ‘variable costing’, in which only variable costs are accumulated and cost per unit is ascertained only on the basis of variable costs. Sometimes, marginal costing and direct costing are treated as interchangeable terms.

The major difference between these two is that, marginal cost covers only those expenses which are of variable nature whereas direct cost may also include cost which besides being fixed in nature identified with cost objective.

Contribution of Marginal Costing:

In marginal costing, costs are classified into fixed and variable costs. The concept marginal costing is based on the behaviour of costs with volume of output. From this approach, it is not possible to identify an amount of net profit per product, but it is possible to identify the amount of contribution per product towards fixed overheads and profits. The contribution is the difference between sales volume and the marginal cost of sales.

In marginal costing it is not possible to determine the profit per unit of product because fixed overheads are charged in total to the profit and loss account rather than recovered in product costing. Contribution is a pool of amount from which total fixed costs will be deducted to arrive at the profit or loss.

The distinction between contribution and profit is given below:

Contribution:

1. It includes fixed cost and profit.
2. Marginal costing technique uses the concept of contribution.
3. At break-even point, contribution equals to fixed cost.
4. Contribution concept is used in managerial decision making.

Profit:

1. It does not include fixed cost.
2. Profit is the accounting concept to determine profit or loss of a business concern.
3. Only the sales in excess of break-even point results in profit.
4. Profit is computed to determine the profitability of product and the concern.

Formulas used in Marginal Costing:

Sales — Variable cost + Fixed cost + Profit

Sales – Variable cost = Contribution

Sales – Variable cost = Fixed cost + Profit

Contribution = Fixed cost + Profit

Contribution – Fixed cost = Profit

Features of Marginal Costing

(a) All costs are categorized into fixed and variable costs. Variable cost per unit is same at any level of activity. Fixed costs remain constant in total regardless of changes in volume.

(b) Fixed costs are considered period costs and are not included in product cost, only variable costs are considered as product costs.

(c) Stock of work-in-progress and finished goods are valued at marginal cost of production.

(d) In marginal process costing, products are transferred from one process to another are valued at marginal costs only.

(e) Prices are determined with reference to marginal cost and contribution margin.

(f) Profitability of departments, products etc. is determined with reference to their contribution margin.

(g) In accounting, marginal cost, the overhead control account in the cost ledger represents only the variable overhead. Fixed costs are taken as expenses in the profit and loss account and thus excluded from costs.

(h) Presentation of data is oriented to highlight the total contribution and contribution from each product.

(i) The difference in the magnitude of opening stock and closing stock does not affect the unit cost of production since all the product costs are variable costs.

Arguments in Favour of Marginal Costing:

(a) Fixed costs are period costs in nature and it should be charged to the concerned period irrespective of the quantum or level of production or sale.

(b) Inclusion of fixed costs in the product cost distorts the comparability of products at different volumes and disturbs control actions. It highlights the significance of fixed costs on profits. In a highly competitive situation, it may be wise to take an order which covers marginal costs and makes some contribution towards fixed costs, rather than loose the order.

(c) The difficulty in apportionment and absorption of fixed costs to product cost will not exist in contribution approach and it is much easier for accounting and determination of product costs.

(d) Marginal cost method is simple in application and is easy for exercise of cost control. It is more informative and simple to understand.

(e) It helps the management with more appropriate information in taking vital business decisions like make or buy, subcontracting, export order pricing, pricing under recession, continue or discontinue a product/division, selection of suitable product mix etc.

(f) Profit-volume analysis is facilitated by the use of break-even charts and profit-volume graphs, and so on.

(g) The analysis of contribution per key factor or limiting resource is a useful aid in budgeting and production planning.

(h) Pricing decisions can be based on the contribution levels of individual products.

(i) The profit and loss statement is not distorted by changes in stock levels. Stock valuations are not burdened with a share of fixed overhead, so profits reflect sales volume rather than production volume.

(j) Responsibility accounting is more effective when based on marginal costing because managers can identify their responsibilities more clearly when fixed overhead is not charged arbitrarily to their departments or divisions.

Criticism against Marginal Costing:

(a) Difficulty may be experienced in trying to separate fixed and variable elements of overhead costs. Unless this can be done with reasonable accuracy, marginal costing cannot be very accurate. Application of common sense and judgment will be necessary.

(b) The misuse of marginal costing approach may result in setting selling prices which do not allow for the full recovery of overhead. This may be most likely in times of depression or increasing competitors when prices set to undercut competitors may not allow for a reasonable contribution margin.

(c) The main assumption of marginal costing is that variable cost per unit will be same at any level of activity. This is only partly true within a limited range of activity. With a major change in activity there may be considerable change in the rates and prices of men, material due to shortage of material, shortage of skilled labour, concessions of bulk purchase, increased transportation costs, changes in productivity of men and materials etc.

(d) The assumption that fixed costs remain constant in total regardless of changes in volume will be correct up to a certain level of output. Some fixed costs are liable to change from one period to another. For example, salaries bill may go up because of annual increments or due to change in the pay rates and due to pay structure. If there is a substantial drop in activity, management may take immediate action to cut the fixed costs by retrenchment of staff, renting of office-premises, warehouses taken on lease may be given-up etc.

(e) Increased automation and mechanization has resulted the reduction in labour costs and increased fixed costs like installation, maintenance and operation costs, depreciation of machinery. The use of marginal costing creates a tendency to disregard the need to recover cost through product pricing. For long-run continuity of the business, it is not good. Assets have to be replaced in the long-run.

(f) Exclusion of fixed overheads from costs may lead to erroneous conclusions. It may create problems in inter-firm comparison, higher demand for salaries and other benefits by employees, higher demand for tax by the Government authorities etc.

(g) The exclusion of fixed overhead from inventory cost does not constitute an accepted accounting procedure and, therefore adherence to marginal costing will involve deviation from accepted accounting practices.

(h) The income-tax authorities do not recognize the marginal cost for inventory valuation.

Absorption Costing and Marginal Costing: Impact on Profit

In absorption costing, stock is valued at total cost while in marginal costing stock valuation is done at variable cost only. This means that in absorption costing, stock valuation is higher than in marginal costing. When production exceeds sales, profit under absorption costing is higher than that of marginal costing. But when sales exceed production, profit under absorption costing is lower than that of marginal costing.

Absorption costing is a principle whereby fixed, as well as, variable costs are allotted to cost units and total overheads are absorbed according to activity level. Absorption costing confirms with the accrual concept by matching costs with revenue for a particular accounting period. Stock valuation complies with the accounting standard and fixed production costs are absorbed into stocks.

Absorption costing method avoids separation of costs into fixed and variable elements, which is not easily and accurately achieved. Cost plus pricing under absorption costing ensures that all costs are covered.

Pricing at the marginal cost may, in the long-run, result in failing to cover the fixed costs. It is important to note that in absorption costing sales must be equal to or exceed the budgeted level of activity otherwise fixed costs will be under absorbed.

The absorption of production overheads under absorption costing has the following impacts:

(i) When production exceeds sales during the period, a higher profit is shown under absorption costing, since the fixed overhead is absorbed over more number of units produced, and carried to next accounting period along with closing inventory.

(ii) When sales are in excess of production, a lower profit is reported under absorption costing. Since, less portion of fixed production overhead is recovered in valuation of closing stock and current period’s cost of production is higher.

The following generalizations to be made on the impact on profit of these two different methods of costing:

(a) Where sales and production levels are constant through time, profit is the same under the two methods.

(b) Where production remains constant but sales fluctuate, profit rises or falls with the level of sales, assuming that costs and prices remain constant, but the fluctuations in net profit figures are greater with marginal costing than with absorption costing.

(c) Where sales are constant but production fluctuates, marginal costing provides for constant profit, whereas under absorption costing, profit fluctuates.

(d) Where production exceeds sales, profit is higher under absorption costing than under marginal costing for the reason that absorption of fixed overheads into closing stock increases their value thereby reducing the cost of goods sold.

(e) Where sales exceeds production, profit is higher under marginal costing. The fixed costs, which previously were part of stock values, are now charged against revenue under absorption costing. Therefore, under absorption costing the value of fixed costs charged against revenue is greater than that incurred for the period.

The choice between using absorption costing and marginal costing will be determined by the following factors:

(a) The system of financial control in use e.g., responsibility accounting is inconsistent with absorption costing.

(b) The production methods in use e.g., marginal costing is favoured in simple processing situations in which all products receive similar attention; but when different products receive widely differing amounts of attention, the absorption costing may be more realistic.

(c) The significance of prevailing level of fixed overhead costs.

Advantages

(i) The technique is simple to understand and easy to operate because it avoids the complexities of apportionment of fixed costs which, is really, arbitrary.

(ii) It also avoids the carry forward of a portion of the current period’s fixed overhead to the subsequent period. As such cost and profit are not vitiated. Cost comparisons become more meaningful.

(iii) The technique provides useful data for managerial decision-making.

(iv) There is no problem of over or under-absorption of overheads.

(v) The impact of profit on sales fluctuations are clearly shown under marginal costing.

(vi) The technique can be used along with other techniques such as budgetary control and standard costing.

(vii) It establishes a clear relationship between cost, sales and volume of output and break­even analysis.

(viii) It shows the relative contributions to profit which are made by each of a number of products, and shows where the sales effort should be concentrated.

(ix) Stock of finished goods and work-in-progress are valued at marginal cost, which is uniform.

Limitations

(i) Segregation of costs into fixed and variable elements involves considerable technical difficulty.

(ii) The linear relationship between output and variable costs may not be true at different levels of activity. In reality, neither the fixed costs remain constant nor do the variable costs vary in proportion to the level of activity.

(iii) The value of stock cannot be accepted by taxation authorities since it deflates profit.

(iv) This technique cannot be applied in the case of contract costing where the value of work-in-progress will always be high.

(v) This technique also cannot be used in the case of cost plus contracts unless fixed costs and profits are considered.

(vi) Pricing decisions cannot be based on contribution alone.

(vii) The elimination of fixed costs renders cost comparison of jobs difficult.

(viii) The distinction between fixed and variable costs holds good only in the short run. In the long run, however, all costs are variable.

 (ix) With the increased use of automatic machinery, the proportion of fixed costs increases. A system which ignores fixed costs is, therefore, less effective.

(x) The technique need not be considered to be unique from the point of cost control.

Applications

The following are the 4 applications of marginal costing:

1. Cost control: in marginal costing there is fixed cost as well as variable cost . fixed cost is controlled by top management and variable cost is controlled by lower management. Sometimes there are the cases when profit decreases even when sale increases in such situations marginal cost helps the concern in finding out the reasons.
2. Evaluation of performance: it helps in evaluating the performance of each sector of concern.
3. Profit planning: profit increased and decreased due to change in selling price, variable cost etc. marginal cost helps in profit planning.
4. Decision making: marginal cost helps in short-term decision-making. Like:

a) Fixing the selling price: Selling price must be equal to the marginal cost. If selling price is more than the marginal cost then there will be loss.

b) Key factor: A factor which puts limit on the production and profit of the business is called key or limiting factor. A company is not able to sell all its production. Sometimes a company can sell all its produces and sometimes not. So choice has to be made regarding whose production has to be increased or who’s decreased.

c) Make or buy decision: It is better for the company to use its idle capacity and produce component parts in the factory itself rather than buying them from the market. If its cost is less than it is better to make it in the factory.

d) Selection of good product mix: This happens in the case when company is producing number of products in that case it is better to select a good product mix which gives more of profit.

e) Effect of change in sale price: Management must be aware of the effect of change in price and make necessary changes from time to time.

f) Closing down activities: Sometimes it becomes necessary for the management to close or suspend some activities of a particular product.

g) Alternative method of production: Marginal costing is helpful in knowing which alternative method of production is to be selected.

h) At the end while selecting alternative course of action management must maintain desired level of profit.

Concept of budget

According to CIMA, London, budget is described as financial and quantitative statement prepared and approved prior to defined period of time, of the policy to be pursued during that period for the purpose of accomplishing a given objective. It may include income, expenditure and employment of capital. In other words, budget refers to a plan covering all the sectors of operations expressed in monetary or quantitative terms for a definite future period.

A budget can be made for a person, family, and group of people, business, government, country, multinational organization or for any thing that makes and spends money. Budget facilitates people to vigilantly look at how much money they are taking in during a given period, and work out the best way to divide it among various categories. When making a personal budget, an individual will normally assign the appropriate amount of money to fixed expenses such as rent, car payments, or utility bills, and then make an educated estimation for how much money they will spend in other categories, such as groceries, clothing, or entertainment.

Batty explained that the entire process of preparing the budget is known as budgeting. Therefore the term budgeting refers to the act of preparing budget (Bhattacharyya, 2011). In technical view, a budget is a statement that includes a conjecture of revenues and expenditures for a period of time, generally a year. It is a broad plan of action intended to accomplish the policy objectives set by the government for the coming year. A budget is a plan and a budget document is a manifestation of the government actions in future. While any plan need not be a budget, a budget has to be necessarily a plan. It explains detailed and location of resources and pro production and taxation or other method for their understanding. More explicitly, a budget contains information about plans, programmes, projects, schemes and activities-current as well as new proposals for the coming year, resource position and income from different sources, including tax and non-tax revenues, actual receipts and expenditure for the previous year; and economic, statistical and accounting data regarding financial and physical performance of the various agencies and organs of the government.

Many persons, corporations and governments plan their financial actions by preparing budgets. In order to get huge success in business area, an organization must plan its financial activities well in advance. It must assess its income and expenditures using historical data of activities in the past and predict future trends. The budget as explained by numerous experts is not just a financial plan that sets forth cost and revenue goals but it is an effective tool for controlling, synchronization, communication, enthusiasm and performance measurement.

Attributes of budget:

A budget must have following features :

1. It should reflect the managerial plans and policies to accomplish business goals and objectives.
2. It must be expressed in monetary or quantitative terms or both.
3. It is comprehensive plan for definite future period.
4. Though it is basically an instrument of planning, it still provides the basis for performance evaluation.

Classification of Budgets

Budget is generally categorized on the basis of the need of respective organization. Preparation of budget may be required by organization for the purpose of its flexibility of production or its functions involved or for the purpose of its period covered.

Classification of budget on the basis of period: On the basis of period, or time covered in budget, it is grouped into short term and long term budget. When budget is prepared for business activity covering a period of more than one year, it is called long term budget. . When budget is prepared for business activity covering a period of one year or less, it is termed as short term budget such as for sales, cash.

Classification of budget on the basis of flexibility of production: In this category, budget is classified into three parts that include fixed, flexible and current budget. Fixed budget is prepared for particular level of production. Flexible budget include series of budgets prepared in respect of different levels of activity during a budget period. Current budget is associated with current business activities of a concern and is prepared under current condition for a very short period.

Classification of budget on the basis of function and coverage: In this heading, budget is grouped into three parts such as operating, financial and master budget. Operating budget is related to different activities of concern. It is a plan of expected revenues and cost. This budget has three categories that include production, cost and sales budget. Financial budgets of function and coverage is associated with all expected financial transactions that are to be incurred during budget period. This is classified into cash and capital expenditure budget. Master budget is the summary of all financial budgets. This budget includes sales budget, production budget, cost budget, cash budget, projected income statement, and projected balance sheet.

Figure: Classification of budget:

The Concept of Budgetary Control

Budgetary control is a method to control costs which includes the preparation of budgets. Budgeting is only a part of the budgetary control. Chartered Institute of Management Accountants explained Budgetary Control as “the establishment of the budgets relating to the responsibilities of the executive to meet the objective of an organization and the continuous comparison of actual with budgeted estimates so that if remedial is necessary it may be taken at an early stage”. CIMA London elucidated that budgeting control is establishment of budgets relating to the responsibilities of executives of a policy and the continuous comparison of actual with budgeted results either to secure by individual action objective of the policy or to provide a basis for its revision. It can be established that budgeting control is a technique of control under which budgets are prepared at first for all business activities of an organization and actual performance of all those business activities are compared with the respective budgeted data so that corrective measures can be taken for any adverse deviation from the budget.

Other experts described it as a continuous process which reviews and adjusts budgetary targets during the financial year and produces a control mechanism to hold budget holder to account. This signifies that budgetary control is a system that encompasses the complete process starting from the preparation of the budget or the action plan, covering monitoring and review culminating in counteractive action.

The characteristics of budgetary control are as follows:

1. Establish target of performance/budget
2. Record the actual performance
3. Compare the actual performance with the budgeted
4. Establish the differences and analyse the reason
5. Act immediately for corrective actions.

Objectives of budgetary control:

Planning: A budget provides a comprehensive plan of action for activities over a definite period of time. Planning helps to anticipate many problems long before they arrive and solutions wanted through careful study.

Next is to coordinate: Budgeting helps managers in coordinating their efforts so that objectives of the organization are synchronized with the objectives of its constituents. This will help in achieving result.

Other objective is to effectively communicate: A budget is a communication tool. The approved budget represents the details of planned activities which assist in communicating the plans. The copies are distributed to the different ministries, extra ministerial departments and agencies.

Another objective is to control: The budget guarantees that plans and objectives are being achieved. Control in budgeting may be combined effort aimed at keeping management informed of what pre-determined plans will achieve. Control comes through variance analysis and reporting.

Objective of budgetary control is to motivate: Careful budgeting control motivates the human resource of the organization.

Performance evaluation: It is most powerful device to management for performance evaluation.

Advantages of Budgetary Control

There are numerous advantages of budgeting control:

It offers an efficient plan based on facts. It provides definite objectives with regard to future operation.

It acts as standard for evaluation of actual performance.

Control: It facilitates management to control each function, sector, ministry or department in order to accomplish the best possible result.

Coordination: It supports and encourages synchronization between departments of activities for the accomplishment of the overall progress of the organization/institution

Cost awareness: It makes management to become more cost conscious and reduce waste and inefficiency in its operations.

Management by exception: It is a time saving device, as attention is directed to areas of more serious needs.

Management Responsibility: It allows each manager to presume responsibility which is clearly established. It clearly defines the area of responsibility for all concerned executives who are engaged in various business activities.

It increases the operational efficiency of various business actions.

It assists in effective utilization of resources of organization.

Limitations of Budgetary Control:

The budget plan is based on estimates: Budgets are based on forecasts and prediction estimates. Absolute exactness is not possible in forecasting and budgeting. The potency or flaw of the budgetary control system depends to a large extent on the precision with which estimates are made.

Danger of rigidity: Budget will not stand the test of time if not flexible because of the dynamic and constant change in business condition.

Management tool: Budget is typically a mechanism of management and cannot reinstate it. Its implementation depends on the will and nature of management concerned. The tool is as good as its applier.

Expensive technique: Budget operation is expensive and need expert team as well as there is incidental expenditure.

Inappropriate condition: Budgets are made round existing organizational structure which may be unsuitable for existing conditions.

In budgets, it is difficult to make clear objectives, fulfil the desired goal.

The process of budgetary control lose its usefulness if it is not revised with changing circumstances.

Importance of Budgetary Control:

In management, there is great significance of budgeting control:

1. It increases competence
2. It reveals inefficiency positions
3. The causes of variances between the budgeted and actual are recognized to chart the remedial process.
4. It checks over-expenditure on the part of spending officer.
5. It reduces huge losses since it is a constant measuring of actual and budgeted.

Essentials of good budgetary control system:

Good budgetary system must fulfill following requirement:

1. It should be headed by senior management of organization.
2. Representatives of all departments should be made part of the budget committee.
3. Organizational goals must be clearly defined.
4. There should be proper management information system.
5. Periodic reports should be made to disclose the performance of budgeting system.
6. Effective follow-up system should be present.

When comparing Budget and Budgetary Control, it can be demonstrated that budget is quantitative plan of action for future period. Whereas Budgetary Control is a system of controlling cost and performances of various business actions through preparation of budgets, assigning responsibilities, evaluation of actual performance by comparing actual results with budgeted data and taking corrective measures in case of any adverse deviation is noticed. Although budget is essential part of Budgetary Control system, both are interrelated and dependent on each other.

To summarize, Budget and Budgetary Control is the staying power of financial control system. In management literature, budget is plan relating to future. It is statement of various activities to be performed in future and these activities are supported funds. Control exercise for execution of budget is called Budgeting control. Budgeting control represents the application of comprehensive system of budgeting in the organization to help the management in the process of its planning, organizing, coordinating, controlling and performance evaluation. It is an effective device to the management to accomplish the business goals and objectives of the organization.

The stress of financial control was in the private sector. Government organize master budget which is supported by budget classification as revenue, capital expenditure and cash budget. The budget targets are traditionally evolved not by agreement but from top to bottom. The incremental approach to budgeting surpasses the zero-base and programme-cum-performance approaches.

The reporting to management is a process of providing information to various levels of management so as to enable in judging the effectiveness of their responsibility centres and become a base for taking corrective measures, if necessary.

Meaning of Reporting:

The term “reporting” mean different things as follows:

(a) Narrating some facts

(b) Reviewing certain matter with its merits and demerits and offering comments

(c) Furnishing data at regular intervals in standardized forms

(d) Submitting specific information for particular purpose upon specific request instruction.

Management reporting refers to the formal system whereby relevant required information is furnished to management by means of reports constantly. Thus ‘report’ is the essence of any manage­ment reporting system.

The term ‘Report’ normally refers to a formal communication, which moves upwards, i.e., for factual communication by a lower level to a higher level of authority in response to orders received from higher level. Reports provide the means of checking the performance. A person, who is issued with orders or instructions to do certain things, should report back what he has done in compliance thereof. Reports may be oral or written and also routine or special.

Objectives or Purpose of Reporting to management

A Management Accountant has to prepare the report for the following purposes.

1. Means of Communication: A report is used as a means of upward communication. A report is prepared and submitted to someone who needs that information for carrying out functions of management.
2. Satisfy Interested Parties: The interested parties of management report are top management executives, government agencies, shareholders, creditors, customers and general public. Different types of management reports are prepared to satisfy above mentioned interested parties.
3. Serve as a Record: Reports provide valuable and important records for reference in the future. As the facts and investigations are recorded with utmost care, they become a rich source of information for the future.
4. Legal Requirements: Some reports are prepared to satisfy the legal requirements. The annual reports of company accounts is prepared to furnished the same to the shareholders of the company under Companies Act 1946. Likewise, audit report of the company accounts is submitted before the income tax authorities under Income Tax Act 1961.
5. Develop Public Relations: Reports of general progress of business and utilization of national resources are prepared and presented before the public. It is useful for increasing the goodwill of the company and developing public relations.
6. Basis to Measure Performance: The performance of each employee is prepared in a report form. In some cases, group or department performance is prepared in a report form. The individual performance report is used for promotion and incentives. The group performance report is used for giving bonus.
7. Control: Reports are the basis of control process. On the basis of reports, actions are initiated and instructions are given to improve the performance.

Requisites of a Good Reporting System:

A good reporting system is a better guide and effective tool for efficient managerial decision ­making.

Hence, the essentials of a good reporting system are as follows:

1. Proper Form:

In order to facilitate decision-making the information supplied should be in proper form. The style and layout of a report depend upon the needs of the individual who will use the same. The report may be submitted in the form of narration [written statement of facts], statisti­cal tabulations, graphs, charts, etc.

2. Proper Time:

Promptness is very important because information delayed is information denied. Reports are meant for action and when adverse tendencies or events are noticed, actions should follow forthwith. The sooner the report is made, the quicker the corrective action be taken.

3. Proper Flow of Information:

The information should flow from the right level of authority to the level of authority where the decisions are to be made. Further complete and consistent infor­mation should flow in a systematic manner.

4. Flexibility:

The system should be capable of being adjusted according to the requirements of the user. For example, production manager should be provided with information relating to his division or area of control only.

5. Facilitation of Evaluation:

The system should distinctively report deviations from standards or estimates. Controllable factors should be distinguished from non-controllable factors and re­ported separately. A good reporting system should give information required for the evaluation of each manager’s area of responsibility in relation to the goals of the organization.

6. Economy:

There is a cost for rendering information and such cost should be compared with benefits derived from the report or loss sustained by not having the report. Economy is an informa­tion aspect to be considered while developing reporting system.

Purpose of Reporting for Management:

The reports serve the following purposes:

(a) Communication Mode:

The basic object of preparation of reports for reporting purposes is to facilitate upward communication. Through reports someone who has some information communicates to higher authority who needs that information for carrying out various functions of management.

Reports serve as a communication mode to communicate relevant information to management executives, government agencies, shareholders, creditors, suppliers, customers or general public. Reports also communicate authentic information to research scholars who are interested in collecting data information for various research matters. Hence reports can be considered most effective communication mode.

(b) Helpful in Record Keeping:

Reports also facilitate record keeping function. Since reports provide valuable and authentic records for future references. Reports usually include facts and findings of investigations which can be stored as valuable information. These stored facts can be of great importance in future.

(c) Meeting Legal Requirements:

Some of the reports are also prepared and submitted to fulfill legal requirements. For instance, annual report of company’s accounts is necessary to be furnished to the shareholders under Companies Act 1956. Similarly, audit report of accounts must accompany the Income tax return under Income tax Act, 1961, Interim reports are submitted quarterly as per clause 41 of listing agreement.

(d) Provides Basis for Taking Important Decisions:

Reports usually contain factual information related with some event. Reports kept as a valuable record also help management in providing basis for taking important decision. For instance salesman’s report and dealers report will provide basis for taking any decision related with sales matters.

(e) Develop Public Relations:

Sometimes reports are also written and submitted presenting information of general progress of business and utilization of national resources. These reports are usually available for general public and help in enhancing goodwill of the reporting entity and hence in developing public relations.

(f) Provide Basis to Measure Performance:

Routine reports about the work performance of employees help the management to measure performance in view of the objects. The reports on performance of employees shall also become basis for promotions and incentives.

(g) Facilitates Control:

Reports also facilitate control process in the organisation. Reports provide a relevant basis of any control process. In normal course of the business, it is on the basis of reports, actions are initiated and instructions are given to improve the performance.

(h) Feedback:

Reports also help the lower levels in providing feedback to the management in form of reactions on decisions taken by the management.

Author and Reece have rightly said, “Reports on what has happened in a business, are useful for two general purposes which may be called information and control respectively.”

So information reports are useful to tell management what is going on. Control reports on the other hand, are useful in assessing personal performance and economic performance.

(i) Help in Combating Changes:

Since business itself is dynamic one, business conditions keep on changing, they pose a serious challenge to the existence of a corporate entity. Reports aim at analyzing the impact of business dynamics and how best changes can be exploited to the benefit of the company.

(j) Facilitates Coordination:

Reporting also helps in coordinating the activities in an organisation. The act of coordinating can be best performed with the help of various reports.

(k) Contact with Users:

Reports act as a mean to remain in touch with consumers, suppliers, shareholders and Government agencies.