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Chapter 33

Budgets
Budget is a financial plan that is agreed in advance and it is a plan not a forecast.

Purpose of budgets

1. Budgeting allows controlling and monitoring: It means budgets can be compared with
the actual and if there is any deviation that can be managed
2. Planning: budgeting enables a business to think ahead. As a result of that business can
anticipate problems and solutions.
3. Coordination: it means budgeting would allow interdepartmental understanding about
the restrictions on payments and how other departments can work it out.
4. Communication: by having a budget everyone in the organization know exactly what
they do because it indicates the priorities of the business and the cost that need to be
kept under control.
5. Efficiency: budgeting will give financial control to lower level and senior level
management. Everyone will be able to make financial decision for the best interest of
the organization. Therefore, waste would be minimized.
6. Motivation: budgeting is a target and could be used to measure the success of
individuals and departments. As a result of that workers will be motivated

Types of Budgets

1. Historical budgets/ incremental budgets

This means that data used to prepare the budget has been gathered in the past. There are
adjustments are made in order to account future known events such as inflation.

A historical budget makes use of historical figure such as

a. Sales volume and sales revenue [sales budget]

b. Production cost [production budget]
c. Various cost items [marketing budget, R and D budget etc.]
d. Profits [profit budget]
e. Cash [cash budget]
f. Master budget [it is the summery of all the budgets together which includes all
the cost revenue and profits]
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Advantages of incremental budgeting

 The budget is stable and change is gradual.

 Managers can operate their departments on a consistent basis.

 The system is relatively simple to operate and easy to understand.

 Conflicts should be avoided if departments can be seen to be treated similarly.

 Co-ordination between budgets is easier to achieve.

 The impact of change can be seen quickly.

Disadvantages of incremental budgeting

 Assumes activities and methods of working will continue in the same way.

 No incentive for developing new ideas.

 No incentives to reduce costs.

 Encourages spending up to the budget so that the budget is maintained next year.

 The budget may become out of date and no longer relate to the level of activity or type
of work being carried out.

 The priority for resources may have changed since the budgets were set originally.

 There may be budgetary slack built into the budget, which is never reviewed-managers
might have overestimated their requirements in the past in order to obtain a budget
which is easier to work to, and which will allow them to achieve favorable results.

2. Zero based budgets:

It is a system of budgeting where no money is allocated on cost or spending unless they can be
justified by the fund holder. This approach does not depend on past cost and the concept of
opportunity cost is applicable in zero based budgeting. It means every time choices are made
on opportunity cost
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There are several advantages of Zero based budgeting

 The allocation of resources would be improved

 Every expenditure has to be justified therefore there will not be unnecessary
cost
 Staff motivation would improve because every financial decision is calculated

However, there are some limitations

 It is time consuming because budgeting could involve collection of data,

analyzing and evaluation
 Skillful decision making may be necessary
 It threatens the existing way of working which would affect motivation
 If the managers can’t justify the spending the money will not be given and
business opportunities are lost

Budgetary control

Budgetary control involves using budgets to look into future and then deciding how to achieve
aims. It involves

 preparations of plans
 Comparison of actual with the planned
 Analyzing the variance

Variance analysis

Variance analysis involves trying to find reasons for the difference between actual plans and the
expected outcomes.

Variance in budgeting is the difference between the planned figure and actual figure

Variance is a favorable variance if it leads to more than expected profit

E.g. actual revenue is greater than budgeted revenue

If the variance leads to lower than expected profits it is known as adverse variance

E.g. Actual Cost is greater than the budgeted cost

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Benefits of variance analysis are

 Variance analysis aids efficient budgeting activity as management wishes to have lower
deviations from the planned budgets.  
 Variance analysis acts as a control mechanism. Analysis of large deviation on key items
helps the company in knowing the causes and it helps management look into possible
ways of how such deviation can be avoided.
 Variance analysis facilitates assigning responsibility and engages control mechanism on
departments where it is required.

Limitations are:

 Variance analysis is an activity which is based on financial results which are released
much later after quarterly closing; there may be a time gap which may affect the
remedial action taking ability to a certain extent.
 Also, not all sources of variance may be available in accounting data which makes acting
upon variances difficult.
 If the budgeting is not made taking into consideration the detailed analysis of each
factor, the budgeting exercise may be loosely done which is bound to deviate from the
actual numbers. Thereafter analyzing variances may not be a useful activity.

Difficulties of budgeting

1. Problems of setting budgets: this involves

 Setting a realistic budget would be difficult because it is also based on forecasted data
 The main budget would be the sales budget but it is subjected to various external
factors
 There can be conflicts among departments to get their portion
 The time used for setting budgets has got an opportunity cost
 If the company set too big objectives workers are not motivated

2. Sometimes budgeting will lead to demotivation of workers if they are not involved in the
budgeting process
3. Some department managers will manipulate budgets for their benefit
4. If the budgets are too rigid the managers will lose business opportunities
5. Short-termism which means managers would lose focus on long term wider picture of
business for the short term gain.