Apt Financial Consultants CPA Review

BUDGETARY PLANNING
Meaning of Budgeting
Budgeting is the process of expressing a plan into monetary terms. A plan is a design of a desired
future and of effective ways of bringing it about. It is prepared in order to fulfill long-term goals of
an organization. Normally the organization is required to prepare long-term plans, which will fulfill
its mission.

Long-term Goals/Objectives
Long-term goals are set taking into consideration both internal and external environment. The
internal environment consists of internal resources such as employees, machines and finance
whereas external environment relates to the factors over which the organization has no control. They
include government policies and decisions, competition, social environment, economic environment
etc.

Meaning of a Budget
A budget is a plan of action expressed in monetary terms and which is used to coordinate the
activities of the organization and their implementation. In formulating the budget, the mission, long-
term goals/objectives, strategies and policies of the organization are taken into consideration.

Reasons for Preparing Budgets

(a) To aid the planning of operations
The plans, which have been formulated, must be translated into monetary terms. This translation will
help the managers to determine how the conditions on the coming period might change and their
financial implications and which steps should be taken in order to respond to these changed
conditions. Therefore, it helps managers to anticipate problems before they occur.

(b) Communication
Through the budget, top management communicates its expectations to lower level management so
as to enable them coordinate their activities to achieve those expectations. This communication is
done in the actual act of preparing it.

(c) Performance Evaluation

The budget provides a useful tool of informing managers on how well their actual performance has
been compared to the budget.

(d) Authorization
Once a budget is passed by proper authorities (normally by Board of Directors or similar body) it
authorizes relevant officials to collect and spend funds in the lines of that budget.

(e) Control
The budget helps managers to manage and control the activities for which they are responsible.
When actual results are compared with the budget, managers can ascertain costs which are not in
line with the budget and which requires their attention. The reasons for deviations are investigated
and appropriate corrective action is taken.

(f) Coordination
The budget facilitates the activities of various segments of the organization to be brought together
and reconciled into a common plan. Without this coordination, each segmental manager would make
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his/her own decision, which may not be in line with the best interest of the whole organization.
Budgeting compels managers to examine the relationship between their operations and those of other
departments. For example, Sales Department can not budget to sell the volume of output, which is
above the Production Department’s ability to produce and vice versa.

(g) Motivation
The budget can be used to influence managerial behaviour and motivating managers to perform in
line with organizational objectives. However, this will be possible only if individuals are allowed to
participate actively in preparing the budget. Otherwise a budget will act as a threat/pressure device
rather than a challenge.

ADMINISTRATION OF THE BUDGETING PROCESS

In a large Organization
In large organizations, the responsibility of preparing the budget of the organization is vested in the
hands of the Budgeting Committee. This committee consists of senior officials of the organization
and is normally under the chairmanship of the Chief Executive Officer. Other members of the
Committee may be representatives of various departments, for example Sales Department, Purchases
Department, Production Department, and Administration Department etc. The Budgeting Committee
is required to ensure that it prepares the budget, which will be presented to the Board of Directors (or
similar body) for approval. This committee therefore, approves departmental budgets and then
prepares the budget for the whole organization. This is done after evaluating the possible results of
implementing the budget. Then it is forwarded to the Board of Directors (or similar body).

The whole budgeting process is coordinated by a Budget Coordinator who is responsible for the
following:
 Issuing the budget time table
 Issuing the budget manual and other information
 Putting together all departmental (segmental) budgets into a single budget for the whole
organization. This will be presented to the Budget Committee.

NB: The coordination of the budgeting process is normally done by the senior member of the
Finance Department.

In a Small Organization
Normally, the head of Finance (or Accounting) Department prepares the budget for a small
organization. After the preparation of the budget, it is discussed by the management and approved.
In case the small organization in question has a board of directors (or similar body), the budget must
be approved by it, after being discussed by the management. However, many small organizations do
not have boards of directors (or similar bodies).

Stages in the Budgeting Process

(i) Communicating Details
The initial step in the budgeting process is to communicate details of the budget policy and
guidelines to those who are responsible for preparation of budgets. This is done by the Budget
Coordinator.

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(ii) Determining the Budget-limiting Factor

After receiving the details of the budget policy, each segment of the organization is required to
determine the budget-limiting factor, which determines the attainable volume of activity of that
department/segment.

(iii) Preparation of the Sales Budget

This is the base for the preparation of all other budgets. However, the production capacity or the
financial capacity to purchase (as the case may be) is taken into consideration while preparing the
Sales Budget.

(iv) Preparation of other Departmental/Segmental Budgets

Managers who are responsible for meeting the budgeted performance should prepare the budgets for
areas for which they responsible. The preparation of segmental budgets is a bottom up process.

(v) Negotiation of Budgets with Superiors

The superior will then incorporate all budgets from their subordinates with his own budget and then
submit the budget to the next higher level. The figures appearing in the budget are the result of
bargaining/negotiation process between managers and their superiors.

(vi) Coordination and Review of Budgets

As the individual budgets go up the organization hierarchy in the bargaining process, they must be
compared in order to make sure that they are consistent to each other. Those budgets which are not
consistent to each other, must be modified so as to make them consistent and compatible with other
conditions, constraints and plans, which are beyond the manager’s knowledge and /or control. The
manager concerned must be informed on the modifications made and their reasons.

(vii) Acceptance of the Budget

When all budgets are consistent to each other, a Master Budget is prepared. The master budget is the
budget summarizing all other budgets. After the approval of the master budget, the budgets are then
passed down through the organization to the relevant responsibility centres. The manager of each
responsibility centre is required to carry out the plans contained in each relevant budget.

(viii) Understanding Budgetary Control Information

Each manager must understand the budgetary control information and the aim of budgetary
information.

How to Determine the Volume of Operation

Determining the Volume of Operation of the Business Organization
For a business-oriented organization, there are many constraints, which may set a limit above, which
the organization will not operate. The organization may not be able to sell every thing. It can sell
what the market can purchase. Even if the market is unlimited the organization will not be able to
sell more than what the internal resources can produce/purchase. Those internal resources (including
the capacity available, skilled manpower, finance, warehouse etc) may be insufficient to produce the
quantity (volume) which is demanded by the market.

Each departmental (segmental) budget will be prepared taking into consideration a given constraint.
Each departmental constraint is referred to as Budget Limiting Factor. There is one budget-limiting
factor for the whole organization and this is referred to as a Principal Budgeting Factor.
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Determining the Volume of Operation of a Non-profit Making Organization

For a non-profit making organization the Principal Budgeting Factor is usually the funds expected to
be available to finance the selected programmes. Normally the non-profit making organization
identifies the costs to be incurred in the coming year in order to carry out the planned activities, and
then it will look for sources of funds to finance those activities. When funds, which are expected to
be available, are not sufficient then the organization will reduce its activities to the level of funds
expected to be available.

The Budget of the Business Organization

A business organization can either be a manufacturing or merchandising organization. The budget of
the business organization has two main parts, namely operating budget and finance budget. When
these two budgets are put together we get a master budget. The master budget is the summary of all
budgets received from all departments.

Operating Budget
Operating budget of the manufacturing organization will have Sales Budget, Production Units
Budget, Cost of Raw Materials Usage Budget, Cost of Raw Materials Purchase Budget, Direct
Labour Budget, Production Overheads Budget, Administration Cost Budget, Marketing Cost
Budget., Proforma Income Statement/Budgeted Income Statement, Proforma Balance
Sheet/Budgeted Balance Sheet

A merchandizing organization’s operating budget will be slightly different from that of the
manufacturing organization. This difference is due to the fact that its activities relate to purchasing
and selling. It does not produce what it sells. Therefore, its operating budget will include Sales
Budget, Purchases Budget, Administration Cost Budget, Marketing Cost Budget, Proforma Income
Statement/Budgeted Income Statement and Proforma Balance Sheet/Budgeted Balance Sheet.

Finance Budget
The Finance Budget for the manufacturing organization is similar to that of the merchandizing
organization. It includes the Cash Budget, Capital Budget

Cash Budget
A Cash Budget shows the expected cash inflows and expected cash outflows. It will therefore,
exclude the following:
 Non-cash items included in the expenses, for example, depreciation expense, amortization of
goodwill and the like.
 Accrued items
However, all deferred items must be included in the Cash Budget

Capital Budget
Capital Budget shows how a fixed asset is going to be purchased and financed and the financial
implications of acquiring it.

Proforma Balance Sheet/Budgeted Balance Sheet.

Proforma Balance Sheet/Budgeted Balance Sheet shows the expected financial position of an
organization at a given date. It shows the expected resources and way of financing the acquisition of
those expected resources. Those expected resources comprise of fixed assets and current assets.
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Fixed assets include plant, motor vehicles, buildings, furniture and the like. Current assets include
stocks (or inventory), debtors (or accounts receivable), prepayments, cash and the like.

Principles of Flexible Budgeting

A flexible budget is a budget prepared at any level of activity. To be able to prepare a flexible budget
one needs to understand the cost behaviour.

Variable cost per unit will remain the same at any level of activity, fixed costs per period will remain
the same at any level of activity provided that that level of activity is still within the relevant range.
Semi variable cost per period will change with the change in activity level but that change in cost is
not in proportion to the change in activity level.

Budgeting Approaches
The following are some of the budgeting approaches:
 Incremental Budgeting System
 Planning, Programming Budgeting System (PPBS)
 Zero-based Budgeting (ZBB)

Incremental Budgeting System

Incremental budgeting System is also referred to as:
 Traditional Budgeting System
 Objects of Expenditure Budgeting System
 Line Item Budgeting System

This is the oldest budgeting technique, which is why it is also known as traditional budgeting
approach. The following steps are carried out when the Incremental Budgeting System is used: -
 Defining the broad objectives of the organization
 Activities which are essential for attaining those objectives are identified
 Expenditure items of each activity are identified and costs are determined.

The above steps are carried out in the first year. In the following year items established in the
previous year are not questioned. The budget will aim at providing sufficient cash to sustain the
previous level of expenditure plus the budget for new items. The previous year expenditure is
adjusted to take into consideration the inflation factor.

Advantages
(i) It is simple, hence allowing comparatively inexperienced people to operate it.
(ii) It is easy to understand
(iii) It facilitates easy statistical comparison from year to year. This is possible due to the fact that
budget items for the
previous year are maintained without being questioned.

Disadvantages
(i) It takes last year expenditure as it is and therefore it does not question the validity of existing (last
year) budget items.
The items with more benefits may be ignored.

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(ii) The budgetee is not required to justify the entire budget. He is only required to justify new items
in the budget.
Therefore if funds are not enough, new budget items are likely to be rejected even though they
may have more
benefits than old (or existing) items.

(iii) Ignoring the volume of activity.

The budget of the last year is taken as it is but adjusted for the effect of inflation. The last year
budget may be appropriate taking into consideration the volume of activity of that year but may it
may not correspond with the volume of activity desired for this year.

(iv) Perpetuation of the previous inefficiency

Previous expenditures may include inefficiency. Adding the funds to the previous year budget items
(adjusting for the effect of inflation) may perpetuate past inefficiency to the future.

(v) No input-output relationship

This budget approach does not consider the input-output relationship. Therefore, it can not be used
for controlling purposes.

Planning, Programming Budgeting System (PPBS)

When using the Planning, Programming Budgeting System the following questions should be
answered: -
 What should be done this year out of multi-year organizational goals?
 How much should be done?
 When should it be done?

The following steps are carried out when the Planning, Programming Budgeting System (PPBS) is
used: -
 Determining the overall objectives of the organization
 Specifying objectives of various programmes
 Organizing the programme structure.
 The programme structure provides the linkage of resources and activities to objectives.
 Undertaking programme analysis which includes:
 Measuring the output in terms of objectives
 Determining the total costs of the programme for several future periods
 Analyzing alternatives and selecting those, which will lead to the attainment of objectives?
 Implementing and reviewing the selected alternatives.

When using the PPBS, allocation of resources is based on the evaluation of programmes and their
alternatives basing on the cost-benefit analysis. Therefore, programmes that offer greater benefit will
be allocated the grater amount of resources.

Since PPBS bases on the approved programmes, it offers an input-output relationship. Therefore it is
a good tool of planning and controlling.

Advantages
(i) PPBS forces the management to identify the activities, functions or programmes to be provided,
there by establishing a basis for evaluating their worthiness.
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(ii) PPBS provides information that will enable the management to assess the effectiveness of its
plans.

(iii) Facilitates more effective allocation of resources.

(iv) Good tool for planning and controlling.

Disadvantages
(i) It needs highly skilled and properly trained staff.
(ii) It is costly in terms of time and other resources.

Zero-based Budgeting System (ZBB)

If the great part of an organization’s costs is discretionary, zero-based budgeting system is ideal for
such an organization.

The following differences of the discretionary costs, committed costs and engineered costs are
important for clear understanding of zero-based budgeting.

Discretionary Costs
These are costs, which an organization can do without or can postpone undertaking the activities
which result into their occurrence. These are costs whose value is a matter of policy. Examples of
discretionary costs are training costs, advertising costs, research & development costs.

Committed Costs
These are costs, which an organization can not do without. Their incurrence is not the matter of
policy. They are influenced by the capacity. Examples of a committed costs are salaries to key
personnel, rent, and insurance.

Engineered Costs
These are costs, which will directly be influenced by the volume of activity. These are variable in
nature and include direct material and direct labour.

If the great part of the organization’s costs is comprised of the discretionary costs and it has no
enough funds to cover all costs, it is going to postpone a part of discretionary costs.

Under the ZBB System the budgetee is required to justify the expenditure for each item whether it is
existing (or old) or new. Therefore old and new budget items compete for allocation of resources on
the basis of cost-benefit comparison.
The budgetee is required to answer the following questions for each budget item:
 Should we perform this function at all?
 What should be the level of performance?
 Is this level actually required?
 Should this operation be performed in this way?
This involves finding possible alternatives of undertaking the operations.
 How much should it cost?

The following steps are carried out when ZBB system is used:
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(i) Breaking the entire organization into small units capable of preparing budgets. These are not
necessarily functional departments.

(ii) Preparation of decision packages.

Each decision unit will prepare the decision package. Decision packages are budget items which will
indicate the objectives for the expenditure, feasibility assessment, alternatives for performing the
same function and tangible and intangible benefits.

(iii) Ranking the decision packages.

Decision packages prepared by decision units will be ranked depending on their costs and benefits.

(iv) Establishing a cut-off point

After ranking the decision packages a cut-off point will be made and the decision packages above
the cut-off point will be allocated resources. All decision packages below the cut-off point will not
be allocated resources regardless whether they are new or existing.

Advantages
(i) Better way of allocating resources.
ZBB questions every budget item thus resulting into better way of allocating scarce resources by
eliminating activities, which will contribute less to the success of the organization.

(ii) It provides basis for measuring achievements.

(iii) ZBB leads to increased staff involvement, which may lead to improved motivation and grater
interest in the job.
(iv) It opens up the debate, which leads to evaluation of plans and optimal allocation of resources.

Disadvantages
(i) It involves a lot of paper work
(ii) It is very time-consuming because old issues are evaluated afresh each year.
(iii) Some budgetees hate to justify every item in the budget.

NB: In practice, these approaches are not mutually exclusive. Normally, each approach tend to
overlap the other, hence a combination of the techniques is normally adopted.

Problems and Dangers of Budgeting

Budgeting is an important process for the anticipating problems before they occur. However, the
budgeting process suffers the following problems and dangers:
 Sometimes it is very difficult and time consuming to seek support and involve all levels of
management.
 It is difficult to develop meaningful forecasts and plans, especially the sales budget which is the
base for all other budgets.
 It is difficult to train all persons to be involved in the budgeting process and winning their
participation.
 It is difficult to formulate objectives, policies, procedures and standards in a realistic manner.
 It is sometimes difficult to cope with changes which were not forecasted and hence not budgeted
for, when preparing the budget.
 Using the budget in the rigid manner.

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Once the budget has been prepared, it must be used intelligently taking into consideration
changes, which might take place. When the budget is used in the rigid manner efficiency and
effectiveness will not be achieved because it will not go with changes taking place after its
formulation.

BUDGETARY CONTROL
Budgetary Control
Budgetary control is defined as a control technique whereby actual results are compared with
budgets and the difference (variance) arising are the responsibility of key individuals who can either
exercise control action or revise original budgets. This is control function exercised by management.

The preparation of budgets relate to the responsibilities of executives to the requirement of policy
and the continuous comparison of actual with budgeted results either to secure by individual action
the objectives of that policy or to provide basis for revisions.

Main Features of Budgetary Control

 Control by responsibility – delegation of authority and accountability
 The continuous comparison of actual/budgeted figures i.e. monitoring of budgets at frequent
intervals.
 Management action required for the significant adverse variances (i.e. Management by
Exception)
 The attainment of objectives
 The revision of the policy where necessary, e.g. where basic assumption change

Budgetary Control involves the following:

Establishment of budgets and the continuous comparison of actual with budgets for achievement of
targets and responsibility accounting involves the revision of budgets in the light of changed
circumstances. Effective budgetary control organization consists of:
 Installation of Budget Centres
Budget centres should be clearly demarcated to facilitate the formulation of various budgets.

 Budget Education
Briefing of employees and managers on the usefulness and limitations of budgetary control
should be done regularly.

 Formulation of Budget Committee

Finance and Budget Committee should be formed under the chairmanship of the Chief Executive
Officer and a team of top management constituting the membership of the committee. The Head
of Finance is the Secretary to the Committee. The main functions of the committee are:
 To formulate broad policies of management relating to the budgetary system.
 To provide budget guidelines and directives for preparation, submission and review of
budgets
 To approve the Master Budget
 To review budget
 To suggest prompt corrective action
 To foster cooperation among members

 Budget Manual
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To facilitate communication and cooperation among members it is essential to prepare written

standardized procedures/routines by means of a budget manual.

Budget manual is defined as a document which spells out responsibilities or persons engaged in
the routine of and the forms and records required for budgetary control. It spells out various steps
in the preparation of different budgets including submission, review, approval and final adoption.
It contains accounts codes for items of expenditure and revenue included in the budget.

 Determination of Budget Period

A budget may cover any time period (weekly, monthly, quarterly, semi-annually and annually).
In any case, the longer the span of budget the less reliable it is. A short term budget is more
reliable and show specific plans and tactics. The budget period should vary with managers’
objectives and the use of budgeting in planning. The time period depends on sales, production,
manufacturing, processing cycle, stability, risk, accuracy of input data, type of product line
seasonality, inventory turnover, availability of resources and government regulations.

Control Limits
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Behavioural Aspects of Budgetary Control Systems

Budgetary control systems are concerned with influencing the behaviours of individuals and groups
within an organization so as to achieve objectives of that organization. Therefore, techniques applied
in the budgetary control system must be established carefully otherwise the budgetary control system
will not help the organization to achieve its objectives.

The following are some of the human behavioural problems:

(i) The budget considered as a threat/pressure device
When trying to influence employees to work harder in order to attain organizational objectives
through a budget, they may consider a budget as a threat/pressure device.

(ii) Poor relationship between individuals

Finance people who undertake budgetary control exercises can be seen as budget policemen by
managers hence leading to poor relationship between Finance people and managers. This leads to
loss of interest in budgetary reports prepared by Finance people.

(iii) Disguising of responsibility

Poor managers may blame the budget for their failure to achieve objectives, especially if there was
no participation in the budget preparation process. They may urge that the budget was not realistic.

(iv) Departmentalism
For fear of getting lesser funds next year, departments may spend up to the last cent allocated to
them. In this way, the needs of departments are put before the organizational needs.

(v) Budget as a tool of minimizing costs

Managers might concentrate on minimizing costs and hence overlook other measures of performance
enhancement, for example productivity improvement.

Those problems can be minimized through the following ways:

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(i) Encouraging participation during the budget preparation process

(ii) Accountants should assume an educational role. They should educate managers on the
importance of accounting controls information.
(iii) Accounting budgetary reports should incorporate other variables besides costs.

ACTIVITY-BASED BUDGETING (ABB)

Introduction
Activity-based Budgeting (ABB) means presenting a budget in terms of the cost of an organization's
products and services, rather than the traditional budget which describes cost factors such as
compensation, travel, and training.
ABB is distinct from Activity-based Cost Accounting (ABC), which means portraying costs (after-
the-fact) of projects and services delivered.
Both ABB and ABC involve the principles of activity-based costing. ABB is done before the year
begins, while ABC is a modification to accounting systems that track costs during the year.
In addition to producing a budget, ABB can be used to calculate a cost-based set of rates (prices) for
all the organization's products and services.
The Way Organizations Budget
The root cause of the problem is the way most organizations budget. Most organizations budgets for
in the form which does not show the cost for each product or service they provide.
Put simply, budgets are generally presented in a manner that does not give clients an understanding
of what they're buying.
Consider a budget spreadsheet, where the columns represent cost factors such as salaries, travel
expenses, professional development, etc. The rows represent deliverables -- i.e., specific projects and
services.
Tutors Stationery etc
Item Travel Hall Hire
Allowances
Short Courses TShs TShs TShs TShs TShs
Consultancy TShs TShs TShs TShs TShs
Research TShs TShs TShs TShs TShs
etc TShs TShs TShs
This kind of spreadsheet is a common, and sensible, way to develop a budget.
The problem is this: After filling in the cells in the spreadsheet, most organizations total the columns
instead of the rows, and present a budget for each of the cost factors. In other words, your budget is
an estimate of how much money you'll need for various cost factors such as compensation, travel,
training, etc.

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