Year: 2020

Budgeting is the process of preparing detailed projections of future amounts. Companies often engage in two types of budgeting:

• Operational budgeting, and
• Capital budgeting

Examples of Operational Budgeting

In a business, the budgeting for operations will include preparing the following projections for the next accounting year:

• Amounts for sales
• Amounts for producing goods
• Amounts for each department’s expenses
• Summarizing the above budgets into a master budget or profit plan
• Cash receipts and disbursements for a cash budget
• Projected financial statements also referred to as pro-forma financial statements

Once prepared and approved, the budgeted amounts are used as a guide or road map in controlling the next year’s business activities.

Example of Capital Budgeting

Capital budgeting involves future projects which overlap several or many future accounting periods. Capital budgeting usually means listing each project along with its cash outlays and expected cash inflows for each year. The amounts should be discounted to their present values and also ranked by priority and profitability.

Once prepared, the capital budget provides a guide for investing in future fixed assets as well as arranging for the financing of the projects.

Approaches to budgeting process

Budgeting can be done in a variety of ways, and it is always a smart choice to be aware of more than just a single way of budgeting. However, two of the most important approaches to budgeting process are:

Top-Down Budget

In the top-down budgeting process, the primary input is made by the top-level executives of the business. The echelon of a certain organizational hierarchy lays down all the guidelines according to which budget will be made. They outline the financial goals that a budget should maintain. Moreover, guidelines related to sales budget, compensation, etc. are all given by the top management. The lower level management is given the least amount of participation in the budgeting process. They are only involved in executing these guidelines.

Bottom-Up Budget

The bottom-up approach to budgeting adopts a more inclusive approach towards the budgeting process. Although the upper-level management gives out the general guidelines related for a budget, however, employees and the lower management formulate these budgets. Each division of the organization forms its budget in accordance to the general guidelines. In the end, the budget of the entire organization is formed by combining the individual budgets of each division. The bottom-up approach for a budgeting process is highly inclusive in nature. The employees overall tend to be much more committed to working under the budget in this approach. This is due to the fact that employees have participated in drawing up a budget and therefore they know that the budget is very acceptable.

Components of budget

There are many divisions of an organization and therefore budgeting for each of the division is specific to its needs. When all the budgets of each division are combined, it results into the final budget, which is often referred to as the “Master Budget”. Various components of the budget are discussed as follows:

Sales Budget

Sales budget outlines the forecasted income stream of the business. It is usually the first budget to be prepared as the revenue generated will ultimately determine the level of expenditure. Under the sales budget, sales of the business are forecasted. Sales are forecasted in terms of sales volume and the sales revenue. The forecasting is done on the following basis:

• Previous pattern of sales
• Economic conditions e.g. rate of inflation, interest rate, exchange rate, economic growth rate
• Political conditions
• State of competition in the market
• Other factors that can affect the sales e.g. technology, etc.

Production Budget

The production budget is of high importance in the overall budgeting process. It determines the number of units of a product that will be produced by the business. It also determines the cost at which the products have to be produced. Production budget is made according to the sales budget. Required sales units, opening inventory and required closing inventory are used to reach the number of units that have to be produced in a budgeted period.

Direct Material Purchases Budget

Direct materials, like the name suggests, are the ones that are being used directly in the production of goods. The budget related to direct material determines the amount and cost of these resources that will be required in the production activity.

Labor, Overhead, and SG&A Budget

Budgets related to labor, overhead and SG&A (selling, general and administrative) are prepared separately. They are then combined under a single head.

The direct labor budget is prepared. Labor that participates in the production process forms the direct labor cost. This budget is prepared according to the number of labor hours and the cost per hour.

Overheads are those costs that are not incurred directly in the production of goods, but are indispensable with regard to the production activity e.g. rent of the factory. The budget of the overhead cost is prepared in relation to the direct labor hours.

SG&A costs are incurred in order to conduct the day to day operations of a business. They consist of fixed and variable costs.

Cash Budget

Cash is known to have a similar importance to a business as blood has to body. No matter how successful a business is, if it runs out of cash, its survival is seriously jeopardized. In order to ensure smooth operations of the business, strong emphasis must be laid upon the development of cash budget. Cash budget helps to formulate in advance the payment and receipt cycles of the business and thus it ensures that cash is readily available to a business. By formulating cash budget, the business can keep track of its accounts receivables and accounts payable. In order to avoid shortage of cash, the business can arrange its credit plans related to accounts receivables and accounts payable accordingly.

Budgeted Financial Statements

Budgeted financial statements are prepared on the basis of each budget component. These budgeted financial statements are called pro forma financial statements. Through the budgeted financial statements, a business will be able to forecast its profits. Profit forecasting is important because it will determine the viability of carrying out the business.

Steps in the budgeting process

Budgeting is a detailed process with several intricate steps leading up to understanding it at large. A step-by-step guide to the budgeting process is given as below.

1. Update budget assumptions

Budgets are always prepared on certain assumptions. Those assumptions could be related to the sales trends, cost trends or environmental conditions. Before embarking on preparing the budget, these assumptions must be thoroughly reviewed according to the recent environmental conditions.

2. Note Available funding

Limited funding can greatly hinder the growth projects of the business. Therefore, in the preparation of budgets adequate attention has to be given to the available funding as the availability of investable funds will determine the initiation of viable projects.

3. Step costing points

The business environment is subject to dynamism. Every day it is posed with challenges that can completely change its cost structure. Therefore, in the budgeting process certain factors that can affect the costing for the business should be closely considered. These factors should be identified beforehand in order to make the budget realistic.

4. Create budget package

In budget package, previous standards related to the budgeting process are taken in order to formulate a budget for the current period. Previous standards are updated according to the recent environmental conditions. Budget package is a kind of outline according to which budget has to be prepared.

5. Obtain revenue forecast

There is no denying the fact that sales budget is the most crucial budget of all. All the budgets are based on the sales budget. Furthermore, sales budget determines whether the business is generating enough revenue necessary for its survival. Therefore, adequate attention must be given to the preparation of sales budget by forecasting demand accurately.

6. Obtain department budgets

The department budgets will help to reach a budgeted expenditure for the budgeted period. Each department will prepare its own budget and then all of them will be combined to become a part of the master budget.

7. Validate compensation

Compensation plans are a significant component of the budgeting process. As compensation is subject to an annual increase, therefore, it should be prepared with great care. The approval for compensation increase should first be taken from the top management, and then it should be augmented in the budgeted compensation plans.

8. Validate bonus plans

In order to maintain the morale of the employees, bonuses are frequently given to out motivated workers. Bonuses act as an appraisal method. Bonus announcements that are not considered in the budgeting process can create havoc in the profits of the business. Therefore, any bonus plans should be taken into consideration beforehand. The top management should be consulted for any bonus plans.

9. Obtain capital budget requests

Capital expenditure ensures expansion of the business. It helps the business to avail the opportunities necessary for business growth. Any capital expenditure plans should be taken in advance, and they should be included in the budgeting process accordingly.

10. Update the budget model

Any changes in the assumptions of the budget model should be updated, and final budget should be prepared accordingly. A delay in this may lead to glitches later on that could cause confusion.

11. Review the budget

The budget should be reviewed thoroughly once it is prepared in order to correct any flaws. A little decimal placed wrongly can create quite an unbalance in the budget sheet.

12. Obtain approval

The budget should be presented to the top management. They will evaluate whether it has been prepared according to their requirements and finally l approve it if it does not need any changes.

13. Issue the budget

The budget should be formally issued after its approval. All the operations there and then will take place according to it.

Methods of Budgeting

1. Incremental Budgeting

Incremental budgeting takes last year’s actual figures and adds or subtracts a percentage to obtain the current year’s budget.  It is the most common method of budgeting because it is simple and easy to understand.  Incremental budgeting is appropriate to use if the primary cost drivers do not change from year to year.  However, there are some problems with using the method:

• It is likely to perpetuate inefficiencies. For example, if a manager knows that there is an opportunity to grow his budget by 10% every year, he will simply take that opportunity to attain a bigger budget, while not putting effort into seeking ways to cut costs or economize.
• It is likely to result in budgetary slack. For example, a manager might overstate the size of the budget that the team actually needs so it appears that the team is always under budget.
• It is also likely to ignore external drivers of activity and performance. For example, there is very high inflation in certain input costs. Incremental budgeting ignores any external factors and simply assumes the cost will grow by, for example, 10% this year.

2. Activity-Based Budgeting

Activity-based budgeting is a top-down budgeting approach that determines the amount of inputs required to support the targets or outputs set by the company.  For example, a company sets an output target of $100 million in revenues.  The company will need to first determine the activities that need to be undertaken to meet the sales target, and then find out the costs of carrying out these activities.

3. Value Proposition Budgeting

In value proposition budgeting, the budgeter considers the following questions:

• Why is this amount included in the budget?
• Does the item create value for customers, staff, or other stakeholders?
• Does the value of the item outweigh its cost? If not, then is there another reason why the cost is justified?

Value proposition budgeting is really a mindset about making sure that everything that is included in the budget delivers value for the business. Value proposition budgeting aims to avoid unnecessary expenditures although it is not as precisely aimed at that goal as our final budgeting option, zero-based budgeting.

4. Zero-Based Budgeting

As one of the most commonly used budgeting methods, zero-based budgeting starts with the assumption that all department budgets are zero and must be rebuilt from scratch.  Managers must be able to justify every single expense. No expenditures are automatically “okayed”. Zero-based budgeting is very tight, aiming to avoid any and all expenditures that are not considered absolutely essential to the company’s successful (profitable) operation. This kind of bottom-up budgeting can be a highly effective way to “shake things up”.

The zero-based approach is good to use when there is an urgent need for cost containment, for example, in a situation where a company is going through a financial restructuring or a major economic or market downturn that requires it to reduce the budget dramatically.

Zero-based budgeting is best suited for addressing discretionary costs rather than essential operating costs.  However, it can be an extremely time-consuming approach, so many companies only use this approach occasionally.

The Master Budget is consolidated summary of the various functional budgets. It has been defined as “a summary of the budget schedules in capsule form made for the purpose of presenting, in one report, the highlights of the budget forecast”.

The definition of this budget given by the Chartered Institute of Management Accountant, England, is as follows:

“The summary budget incorporating its component functional budgets and which is finally approved adopted and employed”.

The master budget is prepared by the budget committee on the basis of co-ordinated functional budgets and becomes the target for the company during the budget period when it is finally approved by the committee.

This budget summarises functional budgets to produce a Budgeted Profit and Loss Account and a Budgeted Balance Sheet as at the end of the budget period as is clear from the form given as follows:

Advantages of the Master Budget:

Following are the main advantages of the master budget:

(1) A summary of all functional budgets in capsule form is available in one report.

(2) The accuracy of all the functional budgets is checked because the summarised information of all functional budgets should agree with the information given in the master budget.

(3) It gives an overall estimated profit position of the organisation for the budget period.

(4) Information relating to forecast balance sheet is available in the master budget.

This budget is very useful the top management because it is usually interested in the summarised meaningful information provided by this budget.

Some of the components of the master budget are briefly explained as follows:

1. Materials and utilities budget:

This budget provides for acquiring raw materials required for production, spare parts for maintenance, labour time, machine time, and energy consumption and so on.

The labour time and machine time is usually related to what a unit of time is budgeted to yield. In other words it relates to the output per unit of time.

2. Control of liquidity:

This budget involves cash flow and is very important in controlling cash and meeting current financial obligations. The budget forecasts cash receipts and outlays for a given period of time and are necessary to control the income and expenses so that there is no shortage of cash to pay for bills and also there in no excessive unused cash which may be unproductive.

3. Revenue and expense budgets:

The revenue budgets should show anticipated sales by product or by geographical territory or by department and so on. In anticipating sales, managers must take into account their competitors, planned advertising expenditures, sales force effectiveness and other relevant factors.

The expense budgets list the primary activities undertaken by a unit to achieve its goals and the costs associated with these activities. These budgets cover all necessary and relevant areas including rent, utilities, supplies, security and so on.

4. Capital expenditure budgets:

These budgets plan for long term investments and include expenditures for new plants and equipment, major installations, replacement of existing equipment, renovation of buildings and so on. These are typically substantial expenditures both in terms of magnitude and duration.

Capital budgeting is a part of long range planning and must be broken into well defined phases of the program known as milestones each phase being budgeted for cost, time and effort in self contained way.

5. Sales budgets:

A sales budget is the direct outcome of sales forecast and is based on the consideration of demand and supply situation, competition, past sales trends, future prediction of sales, seasonal changes that affect sales and so on.

The sales forecasting is based upon such factors as population trends, general economic environment, consumer’s purchasing power, disposable income, price trends of the products, inflation rate and so an.

6. Production budget:

The production budget contains the plan for future manufacturing operations and is based upon the sales forecasts and sales budgets. It aims at obtaining utilization of manufacturing methods and facilities. The budget may be prepared in two parts, one being the production volume budget and the other being the budget for cost of manufacturing.

The production volume budget relates to the production of physical units and involves production planning. The cost of production budget deals with all costs attributable to the manufacture of the product.

7. Balance Sheet:

A balance sheet is composite budget and reflects anticipated assets, liabilities and owner’s equity or net worth at the end of a given period in the future. It provides a forecast of the anticipated financial status of the company at a future date.

All these budgets should be carefully set and should be flexible enough so that any reasonable changes in the values of various variables can be accommodated.

When the actual cost differs from the standard cost, it is called variance. If the actual cost is less than the standard cost or the actual profit is higher than the standard profit, it is called favorable variance. On the contrary, if the actual cost is higher than the standard cost or profit is low, then it is called adverse variance.

Each element of cost and sales requires variance analysis. Variance is classified as follows:

• Direct Material Variance
• Direct Labor Variance
• Overhead Variance
• Sales Variance

Direct Material Variance

Material variances can be of the following categories:

• Material Cost Variance
• Material Price Variance
• Material Usage Variance
• Material Mix Variance
• Material Yield Variance

Material Cost Variance
Standard cost of materials for actual output – Actual cost of material used Or Material price variance + Material usage or quantity variance Or Material price variance + Material mix variance + Material yield variance
Material Price Variance
Actual usage ( Standard Quantity Price – Actual Unit Price) Actual Usage = Actual Quantity of material (in units) used Standard Unit Price = Standard Price of material per unit Actual Unit Price = Actual price of material per unit
Material Usage or Quantity Variance
Material usage or Quantity variance: Standard price per unit (Standard Quantity – Actual Quantity )
Material Mix Variance
Material mix variance arises due to the difference between the standard mixture of material and the actual mixture of Material mix. Material Mix variance is calculated as a difference between the standard prices of standard mix and the standard price of actual mix. If there is no difference between the standard and the actual weight of mix, then: Standard unit cost (Standard Quantity – Actual Quantity ) Or Standard Cost of Standard Mix – Standard cost of Actual Mix Sometimes due to shortage of a particular type of material, standard is revised; then: Standard unit cost (Revised Standard Quantity – Actual Quantity) Or Standard cost of revised Standard Mix – Standard Cost of Actual mix If the actual weight of mix differs from the standard weight of mix, then: Standard cost of revised standard mix × (Total weight of actual mix /mixTotal weight of revised standard mix)
Material Yield Variance
When the standard and the actual mix do not differ, then Yield Variance = Standard Rate × (Actual Yield – Standard Yield) Standard Rate = Standard cost of standard mix /Net standard output (i.e.Gross output−Standard loss)

Direct Labor Variance

Direct labor variances are categorized as follows:

• Labor Cost Variance
• Labor Rate of Pay Variance
• Total Labor Efficiency Variance
• Labor Efficiency Variance
• Labor Idle Time Variance
• Labor Mix Variance or Gang Composition Variance
• Labor Yield Variance or Labor Efficiency Sub Variance
• Substitution Variance

Labor Cost Variance

Standard Cost of Labor – Actual Cost of Labor

Labor Rate of pay Variance

Actual Time taken × (Standard Rate – Actual Rate)

Total Labor Efficiency Variance

Standard rate × (Standard time – Actual time)

Labor Efficiency Variance

Standard Rate (Standard time for actual output – Actual time worked)

Labor Idle Time Variance

Idle Time Variance = Abnormal Idle Time × Standard Rate Total Labor Cost Variance = Labor rate of Pay variance + Total labor Efficiency Variance Total Labor Efficiency Variance = Labor Efficiency Variance + Labor Idle Time Variance

Labor Mix Variance or Gang Composition Variance

If actual composition of labor is equal to standard: LMV = Standard Cost of Standard Composition (for Actual time taken) – Standard Cost of Actual Composition (for Actual time worked) If standard composition of labor revised due to shortage of any specific type of labor but the total actual time is equal to the total standard time: LMV = Standard Cost of Revised Standard Composition (for Actual Time Taken) – Standard Cost of Actual Composition (for Actual Time Worked) If actual and standard time of labor differs: = (Total time of actual labor composition/ Total time of standard labor composition) × Std.cost of std.composition − Std.cost of actual composition In case the Standard is revised and there is a difference in the total Actual and the Standard time: = (Total time of actual labor composition/Total time of revised std./labor composition) × Std.cost of (revised std.composition − actual composition)

Labor Yield Variance

Std. Labor Cost per unit × (Actual Yield In units – Std. Yield in units expected from Actual time worked on production)

Substitution Variance

(Actual hrs × Std. Rate of Std. Worker) – (Actual hrs × Std.Rate actual worker)

 

Fixed Budget:

This budget is drawn for one level of activity and one set of conditions. It has been defined as a budget which is designed to remain unchanged irrespective of the volume of output or turnover attained. It is rigid budget and is drawn on the assumption that there will be no change in the budgeted level of activity. It does not take into consideration any change in expenditure arising out of changes in the level of activity.

Thus, it does not provide for changes in expenditure arising out of change in the anticipated conditions and activity. A fixed budget will, therefore, be useful only when the actual level of activity corresponds to the budgeted level of activity.

A master budget tailored to a single output level of (say) 20,000 units of sales is a typical example of a fixed budget. But, in practice, the level of activity and set conditions will change as a result of internal limitations and external factors like changes in demand and prices, shortages of materials and power, acute competition etc.

It is hardly of any use as a mechanism of budgetary control because it does not make any distinction between fixed, variable and semi-variable costs and provides for no adjustment in the budgeted figures as a result of change in cost due to change in level of activity. It does not provide a meaningful basis for comparison and control. It is also not helpful at all in the fixation of price and submission offenders.

Flexible Budget:

The Chartered Institute of Management Accountants, England, defines a flexible budget (also called sliding scale budget) as a budget which, by recognising the difference in behaviour between fixed and variable costs in relation to fluctuations in output, turnover, or other variable factors such as number of employees, is designed to change appropriately with such fluctuations. Thus, a flexible budget gives different budgeted costs for different levels of activity.

A flexible budget is prepared after making an intelligent classification of all expenses between fixed, semi-variable and variable because the usefulness of such a budget depends upon the accuracy with which the expenses can be classified.

Such a budget is prescribed in the following cases:

(i) Where the level of activity during the year varies from period to period, either due to the seasonal nature of the industry or to variation in demand.

(ii) Where the business is a new one and it is difficult to foresee the demand.

(iii) Where the undertaking is suffering from shortage of a factor of production such as materials, labour, plant capacity etc. The level of activity depends upon the availability of such a factor of production.

(iv) Where an industry is influenced by changes in fashion.

(v) Where there are general changes in sales.

(vi) Where the business units keep on introducing new products or make changes in the design of its products frequently.

(vii) Where the industries are engaged in make to order business like ship-building.

Utility (or Importance) of Flexible Budget

1. Flexible budget provides a logical comparison of budgeted allowances with the actual cost i.e., a comparison with like basis.
2. Flexible budget reckons operational realities and streamlines control function and profit planning. It gives balanced perspective on comparison. When flexible budget is prepared, actual cost at actual activity is compared with budgeted cost at actual activity i.e., two things to a like basis.
3. Flexible budget recognises concept of variability and provides logical comparison of expenditure with actual expenditure as a means of control.
4. With flexible budget, it is possible to establish budgeted cost for any range of activity.
5. A flexible budget is very useful for purposes of budgetary control because it corresponds with changes in the level of activity.
6. It is helpful in assessing the performance of departmental heads because their performance can be judged in relation to the level of activity attained by the organisation.
7. Cost ascertainment at different levels of activity is possible because a flexible budget is prepared for various levels of activity.
8. It is helpful in price fixation and sending quotations.

Difference

	Fixed Budget	Flexible Budget
Meaning	The budget designed to remain constant, regardless of the activity level reached is Fixed Budget.	The budget designed to change with the change in the activity levels is Flexible Budget.
Nature	Static	Dynamic
Activity Level	Only one	Multiple
Performance Evaluation	Comparison between actual and budgeted levels cannot be done accurately, if there is a distinction in their activity levels.	It provides a good base for making a comparison between the actual and budgeted levels.
Rigidity	Fixed Budget cannot be modified as per the actual volume.	Flexible budget can be easily modified in accordance with the activity level attained.
Estimates	Based on assumption	Realistic and Practical