HRD 104: QUANTITATIVE SKILLS II

TOPIC TWO:
BUDGETING AND BUDGETARY CONTROL

Definition
A budget is defined as a plan expressed in money. It is prepared and approved prior to the budget
period and may show income, expenditure, and the capital to be employed.

Importance of Budgeting
i) A budget estimates the profit potential of the business unit.
ii) It is stated in monetary terms although the monetary amounts may be backed up by non-
monetary amounts (e.g., units sold or produced).
iii) It generally covers a period of one year. In businesses that are strongly influenced by
seasonal factors, there may be two budgets per year- for example; apparel companies
typically have a full budget and a spring budget.
iv) It is a management commitment; managers agree to accept responsibility for attaining
the budgeted objectives.
v) The budget proposal is reviewed and approved by an authority higher than the budgeter.
vi) Once approved, the budget can be changed only under specified conditions.
vii) Periodically, actual financial performance is compared to budget, and variances are
analyzed and explained.

Limitations of Budgeting
i. Estimates are used as basis for budget plan and estimates are based, mostly on available
facts and best managerial judgment. Since a lot of human element is involved in
exercising managerial judgment, it is but natural to give some allowance in interpretation
and utilization of estimated results. Budgeting based on inaccurate forecasts is useless as
a yardstick for measuring the actual performance.
ii. The circumstances are constantly changing and, therefore, budgets and budgetary
techniques will not be useful, till they are continually adapted.

iii. In order that a system may be successful, adequate budget education should be imparted
at least through the formative period. Sufficient training programmes should be arranged
to make employees give positive response to budgetary activities.
iv. Execution of budgetary control will not automatically occur. A continuous budget
consciousness throughout the organization is needed for achievement of this objective.
v. Budgetary control cannot reduce the manageria1 function to a formula. It is only a
managerial tool which measures effectiveness of managerial control.
vi. The use of budget may lead to restricted use of resources. Budgets are often taken as
limits. Effort may, therefore, not be made to exceed the performance beyond the
budgeted targets, even though it may be physically possible.
vii. Frequent changes may be called for in budgets due to fast changing industrial climate. It
may be difficult for a company to keep pace with these fast changes, because revision of
budgets is an expensive exercise.

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Principles / Canons of Budgeting

The principles are organized in the following four sections:
A. Planning. This section focuses on the need to ensure that capital assets support core/priority
missions of the agency; the assets have demonstrated a projected return on investment that is
clearly equal to or better than alternative uses of available public resources; the risk associated
with the assets is understood and managed at all stages; and the acquisition is implemented in
phased, successive segments, unless it can be demonstrated there are significant economies of
scale at acceptable risk from funding more than one segment or there are multiple units that need
to be acquired at the same time.

B. Costs and Benefits. This section emphasizes that the asset should be justified primarily by
benefit-cost analysis, including life-cycle costs; that all costs are understood in advance; and that
cost, schedule, and performance goals are identified that can be measured using an earned value
management system.

C. Principles of Financing. This section stresses that useful segments are to be fully funded with
regular appropriations; that as a general rule, planning segments should be financed separately
from procurement of the asset; and that agencies are encouraged to aggregate assets in capital
acquisition accounts and take other steps to accommodate lumpiness or "spikes" (large,
temporary, year-to-year increases in funding) for justified acquisitions. The principles of
financing are full funding, regular appropriations, separate funding of planning segments,
accommodation of lumpiness or spikes and separate capital acquisition accounts.

D. Risk Management. This section is to help ensure that risk is analyzed and managed carefully
in the acquisition of the asset. Strategies can include separate accounts for capital asset
acquisitions, the use of apportionment to encourage sound management, and the selection of
efficient types of contracts and pricing mechanisms in order to allocate risk appropriately
between the contractor and the Government. In addition, cost, schedule, and performance goals
are to be controlled and monitored by using an earned value management system; and if progress
towards these goals is not met, there is a formal review process to evaluate whether the
acquisition should continue or be terminated.

Budgetary Control
Budgetary control is the establishment of budgets relating to responsibilities of executives to the
requirement of a policy, and the continuous comparison of actual with budgeted results either to
secure by individual action the objective of that policy or to provide a basis for revision. It
involves:-
i. Division of the organization on functional basis into different sections (each section is
technically known as a budget center).
ii. Preparation of separate budgets for each “budget center”.
iii. Consolidation of all functional budgets to present overall organizational objectives during
the forthcoming budget period.
iv. Comparison of actual level of performance against budgets. Comparison process is
stretched far enough to declare either attainment of objectives or basis of revision or plan
of action.
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v. Reporting the variances with proper analysis to provide basis for future course of action.

Requirements of a Good Budgeting System

a. Budgeting process should be backed and supported by the chief executive of an
organization.
b. The organizational goal should be quantified and clearly stated. These goals should be
within the framework of the organizations’ strategic and long-range plans.
c. The organizational goals must be divided in functional goals.
d. The functional goals should not conflict with overall organizational objectives.
e. All in the organization should mentally accept the exercise of budget preparation.
f. The persons responsible for execution of budget should participate in budget preparation.
g. The budget should be realistic. It should represent goals that are reasonably attainable.
h. The budget should cover all phases of the organization.
i. The budgeting should be a continuous exercise.
j. Periodic reports should be prepared promptly comparing the budget and actual results.
k. Clear-cut organizational lines should be established with appropriate delegation of
responsibilities for effective implementation.

Objectives of Budgetary Control

1. Planning. Planning is an important managerial function. It helps to decide in advance what to

do, how to do it, when to do it and who is to do it. Planning, thus, helps the managers to
anticipate eventualities, prepare for contingencies for achieving the ultimate goa1s. Budget
preparation drives the managers to plan ahead. Managers express their operational plans for
anticipated business conditions. Without a formal procedure of budgetary control, many
operating managers will not find the time to plan ahead.
2. Communication. The employees of an organization should know organizational aims,
objectives of sub-units (budget centers) and the part that they have to play for their attainment.
Budgets effectively communicate this information to employees.

3. Coordination. To coordinate is to harmonize all the activities of a company so as to facilitate

its working and its success. Coordination will lead to following results:
a. Each department will work in harmony with others,
b. Each department will know the specific role that it has to play in the accomplishment
of overall organizational objectives.
c. The sequential arrangement of activities of different departments is so governed that
overlapping of activities and wastage of time and labour is avoided. A comprehensive
system of budgeting helps to coordinate different functional budgets. For instance, a
budget will preclude the production department from producing more than the sales
department can sell.
4. Motivation. If employees have actively involved (mentally and physically) in budget
preparation and if they are convinced that their personal interests are closely associated with the
success of organizational plan, the budget provides motivation in the form of goals to be
achieved.

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5. Control. Under the system of budgetary control, budget forecast is thoroughly discussed and
reviewed to be finally approved as functional budgets. Thereafter a lot of cuts and adjustments
are made to make functional budgets fit in the organizational objectives. Then budget formation
is followed by a feedback system to pinpoint the extent of variation between actual level of
performance and budgeted level of performance. Thus, the inbuilt mechanism of the routine of
budgetary control is bound to precipitate to an operational control.
6. Approved Plan. A master budget provides an approved summary of results to be expected
from proposed plan of operations. It concerns all functions of an organization and serves as a
guide to executives and departmental heads responsible for various departmental objectives.

Advantages of Budgetary Control

a. A budget programme forces the managers to plan ahead.
b. It forces early consideration of basic policies.
c. All functional heads are compelled to make plans in harmony with the plans of other
departments.
d. It demands the most economical use of labor, materials, facilities and capital.
e. It inculcates a habit of timely, careful, adequate consideration of all factors before
reaching important decisions.
f. The use of budgets removes clouds of uncertainties for lower levels of management
regarding basic policies and objectives.
g. The use of budgets promotes understanding of the problems of co-workers.
h. It facilitates periodic self-analysis of the organization.
i. It aids in obtaining bank credit.
j. Management is forced to give timely and adequate attention to the effect of changing
business conditions.

Budget Committee, Budget Manual and Budget Period

Budget Committee
Although developing budgets is the responsibility of managers, they may receive information
and technical assistance from the staff of a planning group or from a formal budget department
or committee.
The budget department, which generally reports to the corporate controller, provides budget
information and assistance to organizational units, designs budget systems and forms, integrates
the various departmental proposals into a master budget for the organization as a whole, and
reports on actual performance relative to the budget.
The budget committee, made up of senior executives from all functional areas, reviews the
individual budgets, reconciles divergent views, alerts or approves the budget proposals, and then
refers the integrated package to the board of directors. Later, when the plans have been put into
practice, the committee reviews the control reports that monitor progress. In most cases, the
budget committee must approve any revisions made during the budget period.

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Budget Manual
As one of the objectives of budgeting is to improve communications, it is important that a
manual is produced so that everyone in the organization can refer to the manual for guidance and
information about the budgetary process. The budget manual does not contain the actual budgets
for the ensuing period - it is more of an instruction/information manual about the way budgeting
operates in the particular organization and the reasons for having budgeting.

Budget Period
The budget period will differ from firm to firm depending on its financial year. Some firms use
calendar year as their financial year hence the budget period is January 1st to December 31st.

The key Factor or Limiting factor/Principle Budget Factor

The principle budget factor (or limiting factor or key factor) is a factor which, at any given time,
is an overriding planning limitation on the activities of the organization. The principle budget
factor may be production capacity, shortage of labour, materials, finance or, commonly, the level
of demand for goods or services. Because such a constraint will have a pervasive effect (present
or seen and felt everywhere) on all operational plans and budgets, the limiting factor for the
planning period must be identified so that the various budgets can be developed having regard to
the expected limitation. The factor can and does change when one constraint is removed some
other limitation will occur otherwise there would be no limit to the organization’s activities. The
assumption of a single principle budget factor is often too simplistic. In a complex organization,
for example, a divisionalized multi-product company, two or more factors may operate
simultaneously. In such cases, care must be taken to optimize the contribution to the organization
as a whole and not merely try to maximize contribution related to any one limiting factor which
would cause sub-optimality. Where several constraints arise simultaneously the use of
mathematical programming technique, such as linear programming, can be invaluable in
determining the optimum use of resources.

Types of Budget/Master Budget

A master budget is part of the overall organization plan for the next year and includes;
 Organizational goals
 Strategic long-range profit plan
 Master budget (a tactical short-range profit plan)

(a) Sales Budget

The sales budget is the starting point in preparing the master budget, since estimated sales
volume influences nearly all other items appearing throughout the master budget. The sales
budget should show total sales in quantity and value. The expected total sales can be break-even
or target income sales or projected sales. It may be analyzed further by product, by territory, by
customer, and, of course, by seasonal pattern of expected sales.

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Sales Budget
For the Year Ended December 31, 2010
Description Quarter Total for the Year
1 2 3 4
Expected sales in units 1,000 1,800 2,000 1,200 6,000
Unit sales price ($) 150 150 150 150 150
Total 150,000 270,000 300,000 180,000 900,000

(b) Production Budget

The production budget stems from the sales budget, but first question that has to be settled is that
of the level of the stock of finished goods which will be held by the firm. If sales are even over
the year, then production can also be in keeping with the sales figure, and the stock figure can
remain constant. Suppose that the firm sells 50 units every month, and then the firm can produce
50 units per month. In almost every firm a stock level will have to be maintained, the amount of
stock being dependent on factors such as amount of storage space, the estimated amount needed
to cater for breakdowns in productions or for delays in receiving raw materials.

On the other hand sales may not be constant. Sales may average 50 units per month, but the
figures may well be as follows:
January 20 units February 30 units March 60 units
April 80 units May 70 units June 40 units

This would mean that if production level was kept at 50 units per month, there would be a
shortage of 10 units in May when 70 were demanded but only 60 were available for sale - 10 left
over from April plus 50 produced in May. An extra 10 units would need to be held at the
beginning of every year. Any calculations of minimum stock level must include the 10 units. For
example, if minimum stock of 100 is required, stock at the beginning of the year would need to
be 110 units. However, instead of producing the same number of goods each month, the monthly
production could be set to equal the sales figures.

Layout

Production Budget

Desired/planned closing stock xxxxx

Add: Total sales required / estimates xxxxx
Estimated units for sale/stock xxxxx
Less: Planned opening stock (xxxxx)
NET Production Requirement xxxxx

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Example (a)
ELDO HOLDINGS Ltd.
Production Budget

  Dept 1 Dept 2
  Alpha Sigma
1,8
Planned Closing Stock 70 90
8,5 1,6
Add: Planned sales 00 00
10,3 1,6
Estimated units for sale 70 90
(17 (
Less: Planned opening stock 0) 85)
10,2 1,6
Net Production Requirement 00 05

Example (b)
Meru Traders had a stock of 2000 units on 1/1/2005. The firm made the following sales
estimates for the first ½ of 2005.

Month Sales units estimated

January 6,000
February 8,000
March 10,000
April 12,000
May 14,000
June 16,000
If the firm wishes to maintain a minimum stock of 3000 units until March and 4000 units for
thereafter, prepare its production budget to the first ½ of 2005.

Solution
Meru traders production budget

Month Opening stock Planned sale Desired closing Production

units stock units required
January 2,000 6,000 3,000 7,000
February 3,000 8,000 3,000 8,000
March 3,000 10,000 3,000 10,000
April 3,000 12,000 4,000 13,000
May 4,000 14,000 4,000 14,000
June 4,000 16,000 4,000 16,000
Total 66,000 68,000

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Planed production is 68,000 units for the first ½ of 2005. Note that this production budgets
suggests varied production units per month for the six months. What this implies is that either
production capacity be varied every month or very high productive capacity be installed and the
capacity utilization be varied. This means implicit costs which are mitigated by using a uniform
production rate and varying levels of stock. In any case Meru traders desire a ‘minimum’ stock
level with no upper stock limit. Consequently a uniform production rate of 11,333 units per
month (i.e. 68,000٪6) would make production costs uniform throughout the budget period and
meet all sales requirements.

(c) Purchase Budget

This budget is concerned with the material requirements to satisfy the production prices. It shows
the number of units of each material to be purchased and schedules the requirements, usually into
months.

Layout
Gross production requirement as per
production budget xxxxx
Add: Planned closing stock xxxxx
  xxxxx
Less: Planned opening stock (xxxxx)
Units to be purchased xxxxx
Multiply by standard price / unit price xxxxx
Purchase cash requirements xxxxx

OR:

Material Unit & Opening Budgeted Closing Units to Unit Amount

code measure stock consumption stock be price budgeted
produced
1 2 3 4 5 6 7 8
Given given given given given 4+5-3 given 6×7

Example
Product X is manufactured from three materials; x 1, x2 and x3. Each product requires 1 unit of x1,
3 units of x2 and 2 units of x3 and that 50,000 EXE units are required. The forecast opening and
closing stocks of these materials are as indicated below. Prepare a purchase budget.

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Materials
x1 x2 x3
Planned opening 6,000 15,000 8,000
Stock
Planned closing 11,000 10,000 18,000
stock
Standard prices 20 40 30

Solution

Material consumption/ production requirements

x1 = 50,000×1 = 50,000
x2 = 50,000×3 = 150,000
x3 = 50,000×2 = 100,000

Purchase Budget

Material units
  x1 x2 x3
Gross Production Requirement 50,000 150,000 100,000
Add: Planned closing stock 11,000 10,000 18,000
  61,000 160,000 118,000
Less: Planned opening stock (6,000) (15,000) (8,000)
Units to be purchased 55,000 145,000 110,000
Multiply by standard price 20 40 30
Cost of materials Purchased 1,100,000 5,800,000 3,300,000

(d) Cash Budget

The cash budget shows the effect of budgeted activities - selling, buying, paying wages,
investing in capital equipment and so on - on the cash flow of the organization. Cash budgeting
is a continuous activity with budgets being rolled forward as time progresses. The budgets are
usually subdivided into reasonably short periods - months or weeks. Cash budgets are prepared
in order to ensure that there will be just sufficient cash in hand to cope adequately with budgeted
activities. The cash budget may show that there is likely to be a deficiency of cash in some future
period - in which case overdraft or, loans will have to be arranged or activities curtailed - or
alternatively the budget may show that there is likely to be a cash surplus, in which case
appropriate investment or use for the surplus can be planned rather than merely leaving the cash
idle in a current account. The typical cash budget has the general form shown below.

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Cash Budget
Period 1 Period 2 Period 3 etc.

Opening Cash Balance b/f XXX YYY ZZZ AAA

+ Receipts from Debtors
+ Sales of Capital Items
+ Any Loans Received
+ Proceeds for Share Issues
+ Any other Cash Receipts

= Total Cash Available ****** ****** ****** ******

Less
- Payments to Creditors
- Cash Purchases
- Wages and Salaries
- Loan Repayments
- Capital Expenditure
- Dividends
- Taxation
- Any Other Cash Disbursements
= Closing Cash Balance c/f ****** ****** ****** ******

Cash budgets are good examples of the rolling budgets, i.e. where the process of continuous
budgeting takes place whereby regularly each period (week, month, and quarter as appropriate) a
new future period is added to the budget whilst the earliest period is deleted. In this way the
rolling budget is continually revised so as to reflect the most up to date position. The process of
continuous budgeting could be carried out for any type of budget, not just cash budgets.

Cash Budget: Example 1

The opening cash balance on the 1st January was expected to be Kshs.30,000. The sales
budgeted were as follows:

Kshs.
November 80,000
December 90,000
January 75,000
February 75,000
March 80,000

Analysis of records shows that debtors settle according to the following pattern:
60% within the month of sale
25% the month following.
15% the month following.

Extracts from the Purchases budget were as follows:

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Kshs.
December 60,000
January 55,000
February 45,000
March 55,000

All purchases are on credit and past experience shows that 90% are settled in the month of
purchase and the balance settled the month after. Wages are Kshs. 15,000 per month and
overheads of Kshs. 20,000 per month (including Kshs. 5,000 depreciation) are settled monthly.
Taxation of Kshs. 8,000 has to be settled in February and the company will receive settlement of
an insurance claim of Kshs. 25,000 in March. Prepare a cash budget for January, February and
March.

Solution
Workings:
The receipts from sales are as follows:

January Cash (Kshs.)

November (15% x 80,000) 12,000
December (25% x 90,000) 22,500
January (60% x 75,000) 45,000
79,500
February Cash
December (15% x 90,000) 13,500
January (25% x 75,000) 18,750
February (60% x 75,000) 45,000
77,250
March Cash
January (15% x 75,000) 11,250
February (25% x 75,000) 18,750
March (60% x 80,000) 48,000
78,000
Payments for purchases:
January Cash
December (10% x 60,000) 6,000
January (90% x 55,000) 49,500
55,500
February Cash
January (10% x 55,000) 5,500
February (90% x 45,000) 40,500
46,000
March Cash
February (10% x 45,000) 4,500
March (90% x 55,000) 49,500
54,000

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Cash Budget

January February March

Kshs. Kshs. Kshs.

Opening balance 30,000 24,000 17,250
Receipts from sales 79,500 77,250 78,000
Insurance claim 25,000
= Total Cash Available 109,500 101,250 120,250

Payments
Purchases 55,500 46,000 54,000
Wages 15,000 15,000 15,000
Overheads (less depreciation) 15,000 15,000 15,000
Taxation 8,000
= Total Payments 85,500 84,000 84,000
Closing balance c/f 24,000 17,250 36,250

Cash Budget: Example 2

From the following data, prepare a cash budget of the Ray Engineering Company Ltd for the six
months ending 31st December 2006, on the assumption that cash balance in hand on July 1, 2006
will be Kshs. 96,000.
2006 Sales Distribution Raw Wages Production Administration
cost materials overhead overhead
May 95,000 3,600 35,000 9,000 6,000 2,500
June 84,000 3,400 36,000 9,200 6,100 2,400
July 88,000 3,500 40,000 9,800 6,300 2,400
August 84,000 3,200 45,000 10,500 7,000 2,300
September 95,000 14,000 55,000 13,000 8,600 2,400
October 120,000 15,000 40,000 10,400 8,100 3,000
November 125,000 16,000 30,000 9,000 5,900 2,600
December 118,000 7,000 28,000 7,000 4,900 2,500

Additional information:
i) Provide for payment of Kshs. 10,800 in July 2006 and Kshs. 86,000 in
December in respect of capital expenditure detailed in the budget.
ii) It is anticipated that a dividend of Kshs. 23,000 (NET) will be paid in August
iii) 5% Kshs. 10,000 debentures to be redeemed at Kshs. 10,400 on July 1 2006.
iv) Debtors are allowed two months credit (i.e. May sales are paid in July , e.t.c.).
Creditors (i.e. May purchases or overheads are paid in June, e.t.c.)
v) Arrears or advance payment for wages to be ignored.
Solution
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Cash Budget
For the Period ended December 31st, 2006
Details July August September October November December
(Kshs.) (Kshs.) (Kshs.) (Kshs.) (Kshs.) (Kshs.)
Receipts:            
Balance b/d 96,000 112,100 110,400 127,900 121,500 141,400
Add sales 95,000 84,000 88,000 84,000 95,000 120,000
Total receipts 191,000 196,100 198,400 211,900 216,500 261,400
Less: Payments            
Distribution cost 3,400 3,500 3,200 14,000 15,000 16,000
R / Materials procurement 36,000 40,000 45,000 55,000 40,000 30,000
Wages 9,800 10,500 13,000 10,400 9,000 7,000
Production 6,100 6,300 7,000 8,600 8,100 5,900
Administrative 2,400 2,400 2,300 2,400 3,000 2,600
Capital expenditure 10,800 - - - - 86,000
Redemption of debentures 10,400 - - - - -
Dividends - 23,000 - - - -
Sub total payments (78,900) (85,700) (70,500) (90,400) (75,100) (147,500)
Balance 112,100 110,400 127,900 121,500 141,400 113,900

Advantages of Cash Budgets

1. Having to think ahead and plan for the future and express the plans in figures, focuses the
mind in a way that thinking in a general fashion about the future will not do.
2. Seeing that money will have to be borrowed at a particular date will mean that you can
negotiate for a loan in advance, rather than at the time when you have actually run out of
cash.
3. Knowing about the need to borrow in advance also widens the possible pool of lenders..
4. Knowing that there is going to be surplus cash in advance will enable you to investigate
properly how you can invest this surplus cash until required, thus earning interest or other
investment income.

Fixed and Flexible Budgets

A Fixed Budget is one which is designed to remain unchanged irrespective of the volume of
output or turnover attained. The major purpose of a fixed budget is at the planning stage when it
serves to define the broad objectives of the organization. It is likely to be of little value for
control purposes unless by chance the actual activity level turns out to be exactly as planned - an
unlikely circumstance.

After actual results are compared with the budgeted results expected in a fixed budget, they will
have deviated for two reasons.

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1. While the actual and budgeted volumes of production and sales may be the same there
may be a difference on actual and budgeted costs.
2. The volumes of actual and budgeted units of sales and production may vary, so that the
cost will be different because of different volumes.

A Flexible budget is a budget which allows for changing levels. It is designed to adjust the
budgeted cost levels to suit the level of activity actually attained. This is achieved by analyzing
each item of cost contained in the budget into fixed and variable elements. In this way an
estimate can be made of the expected costs for the actual activity level experienced. This process
is often known as 'flexing' the budget. Variations that occur in a budget are called variances.

Forecasting and Budgets

A budget is a management plan, with the implicit assumption that positive steps will be taken by
the budgeter [the managers who prepare the budget] to make actual events correspond to the
plan. A forecast is merely a prediction of what will most likely happen, carrying no implication
that the forecaster will attempt to shape the events realized.

A forecast has the following characteristics:

 A forecast may or may not be stated in monetary terms.
 It can be for any time period.
 The forecaster does not accept responsibilities for meeting the forecasted results.
 Forecasts are not usually approved by higher authority.
 A forecast is normally updated as soon as new information indicates there is a change in
conditions
 Variances from forecasts are not analyzed formally or periodically.

An example of a forecast is one that is made by the treasurer’s office to help in cash planning.
Such a forecast includes estimates of revenue, expenses and other items that affect cash flows.
The treasurer however has no responsibility for making the actual sales. From management’s
point of view, a financial forecast is exclusively a planning tool, whereas a budget is both a
planning tool and a control tool.

The importance of budgeting to managers;

- The budgetary process compels managers to think and to prepare for changing
conditions.
- Budgets are aids in planning, communicating, setting standards of performance,
motivating personnel towards goals, measuring results and directing attention to
problems that need investigation.
- Provides definite expectations that are the best framework to evaluate performance.

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