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BUDGETING & BUDGETARY CONTROL

What is a budget?
A budget is a quantitative detailed plan prepared for a specific time period. It is normally expressed in
financial terms and prepared for one year.
The main objectives for producing budgets are:
Budgeting serves a number of purposes:
Planning
A budgeting process forces a business to look to the future. This is essential for survival since it stops
management from relying on ad hoc or poorly coordinated planning.
Control
Actual results are compared against the budget and action is taken as appropriate.
Communication
The budget is a formal communication channel that allows junior and senior managers to converse.
Coordination
The budget allows coordination of all parts of the business towards a common corporate goal.
Evaluation
Responsibility accounting divides the organization into budget centers, each of which has a manager who
is responsible for its performance.
Motivation
The budget may be used to evaluate the actions of a manager within the business in terms of the costs and
revenues over which they have
Control.
The budget may be used as a target for managers to aim for. Reward should be given for operating within
or under budgeted levels of expenditure. This acts as a motivator for managers.
Authorization
The budget acts as a formal method of authorization to a manager for expenditure, hiring staff and the
pursuit of plans contained within the budget.
Delegation
Managers may be involved in setting the budget. Extra responsibility may motivate the managers.
Management involvement may also result in more realistic targets.

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BUDGET PREPARATION PROCESS

Steps
1. Budget aims
 Strategic aims.
 Key assumptions.
2. Identify the principal budget factor
 Sales demand for production environment.
 Cash resource for nonprofit making organization.
3. Prepare the sales budget
Start with the principal budget factor:
 Marketing department function.
 Price/volume relationship.
4. Prepare all other functional budgets
Prepare each functional budget separately.
Participatory process
 Local knowledge.
 Promotes ownership.
5. Negotiation
Meeting between junior management and senior managers to ensure that the budget is a realistic
target. In particular the aim is to eliminate budgetary slack.
6. Review
Bring all individual functional budgets together to form a master budget, an overall budget for the
whole organization.
Budget assessed for:
 Feasibility
 Acceptability
Once completed budgeted financial statements and cash flow statements can be prepared.
7. Acceptance
Acceptance means that the budget becomes a formal authorization for all levels of management to
take action for and on behalf of the company.
TYPES OF BUDGET
Approaches to budgeting:
There are a number of different budgetary systems:
(i) Top down vs bottom up budgeting
(ii) Incremental budgeting
(iii) Zero-based budgeting (ZBB)
(iv) Rolling budgets
(v) Activity based budgeting (ABB)

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BUDGETING AND PARTICIPATION

There are basically two ways in which a budget can be set: from the top down (imposed budget) or from the
bottom up (participatory budget).
IMPOSED STYLE
An imposed/top down budget is 'a budget allowance which is set without permitting the ultimate budget
holder to have the opportunity to participate in the budgeting process'
Advantages of imposed style
There are a number of reasons why it might be preferable for managers not to be involved in setting their
own budgets:
1. Involving managers in the setting of budgets is more time consuming than if senior managers
simply imposed the budgets.
2. Managers may not have the skills or motivation to participate usefully in the budgeting process.
3. Senior managers have the better overall view of the company and its resources and may be better
placed to create a budget which utilizes those scarce resources to best effect.
4. Senior managers also are aware of the longer term strategic objectives of the organization and can
prepare a budget which is in line with that strategy.
5. Managers may build budgetary slack or bias into the budget in order to make the budget easy to
achieve and themselves look good.
6. Managers cannot use budgets to play games which disadvantage other budget holders.
7. By having the budgets imposed by senior managers, i.e. someone outside the department, a more
objective, fresher perspective may be gained.
8. If the participation is only pseudo participation and the budgets are frequently drastically changed
by senior management, then this will cause dissatisfaction and the effect will be to demotivate staff

PARTICIPATIVE BUDGETS
Participative/bottom up budgeting is 'A budgeting system in which all budget holders are given the
opportunity to participate in setting their own budgets'
Advantages of participative budgets
1. The morale of the management is improved. Managers feel like their opinion is listened to, that
their opinion is valuable.
2. Managers are more likely to accept the plans contained within the budget and strive to achieve the
targets if they had some say in setting the budget, rather than if the budget was imposed upon
them. Failure to achieve the target that they themselves set is seen as a personal failure as well as
an organizational failure.
3. The lower level managers will have a more detailed knowledge of their particular part of the
business than senior managers and thus will be able to produce more realistic budgets.

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EXERCISE 1
Bottom up budgeting is generally seen as preferable because it leads to improved managerial motivation
and performance. However, there are situations for which top down budgeting is preferable. Describe three
(3) situations where top down budgeting would be more applicable.
INCREMENTAL BUDGETS
An incremental budget starts with the previous period’s budget or actual results and adds (or subtracts) an
incremental amount to cover inflation and other known changes.
It is suitable for stable businesses, where costs are not expected to change significantly. There should be
good cost control and limited discretionary costs.

Advantages Disadvantages
1 Quickest and easiest method 1 Builds in previous problems
and inefficiencies
2 Suitable if the organization is stable and 2 Uneconomic activities may be continued. E.g.
historic figures are acceptable since only the firm may continue to make a component in-
the increment needs to be justified house when it might be cheaper to outsource.
3 Managers may spend unnecessarily to use up
their budgeted expenditure allowance this
year, thus ensuring they get the same (or
a larger) budget next year

EXERCISE 2
AW Inc produces two products, A and C. In the last year (20X4) it produced 640 units of A and 350 units of
C incurring costs of $672,000. Analysis of the costs has shown that 75% of the total costs are variable.
60% of these variable costs vary in line with the number of A produced and the remainder with the number
of C.
The budget for the year 20X5 is now being prepared using an incremental budgeting approach. The
following additional information is available for 20X5:
 All costs will be 4% higher than the average paid in 20X4
 Efficiency levels will remain unchanged.
 Expected output of A is 750 units and of C is 340 units.
REQ: What is the budgeted total variable cost of products A and C for the full year 20X5?
ZERO-BASED BUDGETING (ZBB)
Zero-based budgeting requires that activities be re-evaluated as part of the budget process so that each
activity, and each level of activity, can justify its consumption of the economic resources available.
This is in contrast to incremental budgeting, where the current budget is increased to allow for expected
future conditions. Zero-based budgeting prevents the carrying forward of past inefficiencies that can be a
feature of incremental budgeting and focuses on activities rather than departments or programs.

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Each activity is treated as though it was being undertaken for the first time and is required to justify its
inclusion in the budget in terms of the benefit expected to be derived from its adoption.
It is suitable for:
 Allocating resources in areas were spend is discretionary, i.e. nonessential. For example, research
and development, advertising and training.
 Public sector organizations such as local authorities
Stages in the implementation of ZBB:
1. Activities are identified by managers. These activities are then described in what is called a
‘decision package’. This decision package: -
 Analyses the cost of the activity
 States its purpose
 Identifies alternative methods of achieving the same purpose
 Establishes performances measures for the activity
 Assesses the consequence of not performing the activity at all or of performing it at
different levels.
This decision package is prepared at the base level, representing the minimum level of service
or support needed to achieve the organization’s objectives. Further incremental packages may
then be prepared to reflect a higher level of service or support.
2. Management will then rank all the packages in the order of decreasing benefits to the organization.
This will help management decide what to spend and where to spend it.
3. The resources are then allocated based on order of priority up to the spending level.

Advantages Disadvantages
1 Inefficient or obsolete operations 1 It emphasizes short-term benefits to the
can be identified and discontinued detriment of long-term goals.
2 ZBB leads to increased staff involvement 2 The budgeting process may become too rigid
at all levels since a lot more information and the organization may not be able to react
and work is required to complete the to unforeseen opportunities or threats.
budget 3 The management skills required may not be
present
3 It responds to changes in the business 4 Managers may feel demotivated
environment due to the large amount of time
spent on the budgeting process
4 Knowledge and understanding of the cost 5 Ranking can be difficult for different type of
behavior patterns of the organization will activities or where the benefits are qualitative
be enhanced in nature
5 Resources should be allocated efficiently
and economically

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EXERCISE 3
For a number of years, the research division of Z Inc has produced its annual budget (for new and
continuing projects) using incremental budgeting techniques. The company is now under new management
and the annual budget for 20X4 is to be prepared using ZBB techniques. Explain how Z Inc could operate a
ZBB system for its research projects
ROLLING BUDGETS
A budget (usually annual) kept continuously up to date by adding another accounting period (e.g. month or
quarter) when the earliest accounting period has expired.
Suitable for:
 Accurate forecasts cannot be made. For example, in a fast moving environment.
 or for any area of business that needs tight control
Advantages Disadvantages
1 Planning and control will be based on a 1 Rolling budgets are more costly and time
more accurate budget. consuming than incremental budgets
2 Rolling budgets reduce the element of 2 May demotivate employees if they feel that
uncertainty in budgeting since they they spend a large proportion of their time
Concentrate on the short-term when the budgeting or if they feel that the budgetary
degree of uncertainty is much smaller. targets are constantly changing
3 There is always a budget that extends 3 There is a danger that the budget may become
into the future (normally 12 months) the last budget 'plus or minus a bit'
4 It forces management to reassess the 4 increase in budget work may lead to less
budget regularly and to produce budgets control of the actual results
which are more up to date
EXERCISE 4
A company uses rolling budgeting and has a sales budget as follows;
Quarter Quarter Quarter Quarter Total
Sales ($) 125,750 132,038 138,640 145,572 542,000
Actual sales for Quarter 1 were $123,450. The adverse variance is fully explained by competition being
more intense than expected and growth being lower than anticipated. The budget committee has proposed
that the revised assumption for sales growth should be 3% per quarter.
REQUIRED: Update the sales budget as appropriate.
ACTIVITY BASED BUDGETING (ABB)
Activity-based budgeting (ABB) would need a detailed analysis of costs and cost drivers so as to determine
which cost drivers and cost pools were to be used in the activity-based costing system. However, whereas
activity-based costing uses activity-based recovery rates to assign costs to cost objects, ABB begins with
budgeted cost-objects and works back to the resources needed to achieve the budget.
Or, put more simply, preparing budgets using overhead costs from activity based costing methodology.

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Advantages Disadvantages
1 Organizational resources are allocated 1 A considerable amount of time and effort might be
more efficiently due to the detailed cost needed to establish an ABB system, for example to
and activity information obtained by identify the key activities and their cost drivers.
implementing an ABB system.
2 It avoids slack that is often linked to 2 ABB might not be appropriate for the organization
incremental budgeting due to its detailed and its activities and cost structures.
assessment of the activities and
resources needed to support planned
sales and production.
3 In ABB the costs of support activities are 3 A problem with ABB could be to identify clear
not seen as fixed costs to be increased individual responsibilities for activities.
by annual increments, but as depending
to a large extent on the planned level of
activity
4 It provides a useful basis for monitoring 4
increase in budget work may lead to less control of
and controlling overhead costs, by the actual results
drawing management attention to the It could be argued that in the short term many
actual costs of activities and comparing overhead costs are not controllable and do not vary
actual costs with what the activities were directly with changes in the volume of activity for
expected to cost. the cost driver. The only cost variances to report
would be fixed overhead expenditure variances for
each activity.
NOTE: The advantages & disadvantages of ABB are similar to those provided by activity-based-costing
(ABC).
EXERCISE 5
The operating divisions of Z plc have in the past always used a traditional approach to analysing costs into
their fixed and variable components. A single measure of activity was used which, for simplicity, was the
number of units produced. The new management does not accept that such a simplistic approach is
appropriate for budgeting in the modern environment and has requested that the managers adopt an
activity based approach in future.
REQUIRED:
Explain how ABB would be implemented by the operating divisions of Z plc.

Selecting a suitable budgetary system

As seen, there are many approaches to budgeting and an organization will wish to select a system which is
most appropriate.
Factors, which will determine suitability include:
(i) Type and size of organization
(ii) Type of industry

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(iii) Type of product and product range

(iv) Culture of the organization.

EXERCISE 6
Select and justify a suitable budgeting system for a company operating in the mobile phone market.

BUDGETARY CONTROL SYSTEM

A budgetary control system is a means of monitoring revenue and costs and thereby exercising control in
an entity by developing budgets and comparing budgeted figures with actual results. This system highlights
any discrepancies and allows corrective action to be taken.
Budgetary control cycle:

Budgetary control helps management to take timely corrective action in cases where actual performance is
not in line with the budget.

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PRACTICE QUESTION
Camron Plc manufactures and sells two products Bing and Xing. The company is planning its budget for
the forthcoming year ending on 31 December 20X9. The following are the expectations for 20X9:
1. Finished products details

2. Production details
(i) Direct material

(ii) Direct labour

For the production of one unit of Bing and Xing, 2 and 3 direct labour hours are required
respectively. Labour is paid at Tshs4,800 per hour.
(iii) Quarterly budgeted receipts and payments are as follows:

NOTE: Camron Plc had a cash balance of Tshs5,800,000 as of 31 December 20X8.

REQUIRED
Prepare the following budgets for the year ended 31 December 20X9 for Camron Plc:
(i) Sales budget
(ii) Production budget (units only)
(iii) Direct material budget (usage and purchase)
(iv) Direct labour budget
(v) Cash budget

Laurian, Vicent CPA(T), MSc