THE FUNDAMENTALS OF BUDGETING

A budget is a comprehensive formal management plans expressed in quantitative

terms, describing the expected operations of an organization over some future time
period. A budget is a 'quantitative expression of a plan for a defined period of time. It
may include planned sales volumes and revenues; resource quantities, costs and
expenses; assets, liabilities and cash flows.' CIMA Official Terminology

A budget deals with a specific entity, covers a specific future time period and is
expressed in quantitative terms.

Why do organisations prepare budgets?

Budgeting is a multi-purpose activity.

Reasons for preparing budgets

Here are some of the reasons why budgets are used.n Detail

Compel planning Budgeting forces management to look ahead, to set out detailed
plans for achieving the targets for each department, operation and (ideally) each
manager and to anticipate problems.

Communicate ideas and plans A formal system is necessary to ensure that each
person affected by the plans is aware of what he or she is supposed to be doing.
Communication might be oneway,with managers giving orders to subordinates, or there
might be a two-way communication .

Coordinate activities The activities of different departments need to be coordinated to

ensure everyone in an organisation is working towards the same goals. This means, for
example, that the purchasing department should base its budget on production
requirements and that the production budget should in turn be based on sales
expectations.

Provide a framework for responsibility accounting

Budgets require that managers are made responsible for the achievement of

budget targets for the operations under their personal control.

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Establish a system of control Control over actual performance is provided by the
comparisons of actual results against the budget plan. Departures from budget can then
be investigated and the reasons for the departures can be divided into controllable and
uncontrollable factors.

Provide a means of performance evaluation

Budgets provide targets which can be compared with actual outcomes in order to
assess employee performance.

Motivate employees to improve their performance

The interest and commitment of employees can be retained if there is a system that lets
them know how well or badly they are performing. The identification of controllable
reasons for departures from budget with managers responsible provides an incentive for
improving future performance.

Here's what the Official Terminology has to say:

Budget purposes: 'Budgets may help in authorising expenditure, communicating

objectives and plans, controlling operations, co-ordinating activities, evaluating
performance, planning and rewarding performance. Often, reward systems involve
comparison of actual with budgeted performance.' CIMA Official Terminology

Meaning of budget to different people

A budget, since it has different purposes, might mean different things to different
people.

A budget might be a forecast, a means of allocating resources, a yardstick or a

target. Forecast It helps managers to plan for the future. Given uncertainty about the
future, however, it is quite likely that a budget will become outdated as events occur and
so the budget will cease to be a realistic forecast. New forecasts might be prepared that
differ from the budget.

A forecast is what is likely to happen; a budget is what an organisation wants to happen.

(These are not necessarily the same thing.)

Means of allocating resources

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It can be used to decide how many resources are needed (cash, labour and so on) and
how many should be given to each area of the organisation's activities. As we saw when
we looked at limiting factor analysis, resource allocation is particularly important when
some resources are in short supply. Budgets often set ceilings or limits on how much

administrative departments and other service departments are allowed to spend in the

period. Public expenditure budgets, for example, set spending limits for each
government department.

Yardstick By comparing it with actual performance, the budget provides a means of

indicating where and when control action may be necessary (and possibly where some
managers or employees are open to censure for achieving poor results).

Target A budget might be a means of motivating the workforce to greater personal

accomplishment, another aspect of control.

COMPONENTS OF MASTER BUDGET

The master budget is the total budget package for an organization; it is the end product
that consists of all the individual budgets for each part of the organization aggregated
into one overall budget for the entire organization.

The two major components of master budget are the operating budget and the
financial budget.

Operating budget. It focuses on income statement and its supporting schedules. It is

also called profit plan. However, such budget may show a budgeted loss, or can be
used to budget expenses in an organization or agency with no sales revenues.

Financial budget. It focuses on the effects that the operating budget and other plans
will have on cash.

The usual master budget for a non-manufacturing company has the following
components.

1. Operating budget includes: 2. Financial budget include:

a. Sales budget a. Capital budget

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 b. Purchases budget b. Cash budget

c. Cost of goods sold budget c. Budgeted balance sheets

d. Operating expense budget d. Budgeted statement of cash flows

In addition to the master budget there are countless forms of special budgets and
related reports. For example, a report might detail goals and objectives for
improvements in quality or customer satisfaction during the budget period.

A framework for budgeting

Budget committee

The budget committee is the coordinating body in the preparation and administration of
budgets.

The budget committee is usually headed up by the managing director (as chairman) and
is assisted by a budget officer who is usually an accountant. Every part of the
organisation should be represented on the committee, so there should be a
representative from sales, production, marketing and so on. Functions of the budget
committee include the following.

 Coordination and allocation of responsibility for the preparation of budgets

 Issuing of the budget manual

 Timetabling

 Provision of information to assist in the preparation of budgets

 Communication of final budgets to the appropriate managers

 Monitoring the budgeting process by comparing actual and budgeted results

The budget period

A budget period is a 'period for which a budget is prepared, and used, which may then
be sub-divided into control periods'. CIMA Official Terminology

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Except for capital expenditure budgets, the budget period is usually the accounting year
(sub-divided into 12 or 13 control periods).

Responsibility for budgets

The manager responsible for preparing each budget should ideally be the manager
responsible for carrying out the budget.

For example, the preparation of particular budgets might be allocated as follows.

(a) The sales manager should draft the sales budget and the selling overhead cost
centre budgets.

(b) The purchasing manager should draft the material purchases budget.

(c) The production manager should draft the direct production cost budgets.

The budget manual

The budget manual is a collection of instructions governing the responsibilities of

persons and the procedures, forms and records relating to the preparation and use of
budgetary data.

The budget manual is a 'detailed set of guidelines and information about the budget
process typically including a calendar of budgetary events, specimen budget forms, a
statement of budgetary objectives and desired results, listing of budgetary activities and
budget assumptions, regarding, for example, inflation and interest rates'.CIMA Official
Terminology

A budget manual may contain the following.

(a) An explanation of the objectives of the budgetary process

(i) The purpose of budgetary planning and control

(ii) The objectives of the various stages of the budgetary process

(iii) The importance of budgets in the long-term planning of the business

(b) Organisational structures

(i) An organisation chart

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(ii) A list of individuals holding budget responsibilities

(c) An outline of the principal budgets and the relationship between them

(d) Administrative details of budget preparation

(i) Membership and terms of reference of the budget committee

(ii) The sequence in which budgets are to be prepared

(iii) A timetable

(e) Procedural matters

(i) Specimen forms and instructions for their completion

(ii) Specimen reports

(iii) Account codes (or a chart of accounts)

(iv) The name of the budget officer to whom enquiries must be sent

Steps in the preparation of a budget

The first task in the budgetary process is to identify the principal budget factor. This is
also known as the key budget factor or limiting budget factor. The principal budget
factor is the factor which limits the activities of an organisation.

The procedures for preparing a budget will differ from organisation to organisation but
the steps described below will be indicative of the steps followed by many
organisations. The preparation of a budget may take weeks or months and the budget
committee may meet several times before the master budget (budgeted income
statement, budgeted statement of financial position and budgeted cash flow) is finally
agreed. Functional budgets (sales budgets, production budgets,direct labour budgets
and so on), which are amalgamated into the master budget, may need to be amended
many times over as a consequence of discussions between departments, changes in
market conditions and so on during the course of budget preparation

Functional budgets

Functional/departmental budgets include budgets for sales, production, purchases and

labour.

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A departmental/functional budget is a 'budget of income and/or expenditure applicable
to a particular function frequently including sales budget, production cost budget (based
on budgeted production, efficiency and utilisation),purchasing budget, human resources
budget, marketing budget and research and development budget'.CIMA Official
Terminology.

EXAMPLE.

Hachitoshi Ltd makes one product, which sells for K180 each, and prepares functional
budgets on a monthly basis. For the first three months of 2007, the following figures are
proposed:

Sales: Month 1 10,000 units

Month 2 11,000 units

Month 3 10,000 units.

A closing stock of 10% of the next month’s sales is required,the forecast sales for month
4 are 12,000 units.The standard material cost of one unit of finished product is:

Material X 3 units at K10 per unit

Material Y 2 units at K20 per unit

Material Z 1 unit at K15 per unit

The standard direct labour cost of one unit of finished product is:

Department A 2 hours at K6 per hour

Department B 2 hours at K6 per hour

Department C 3 hours at K5 per hour

Required:

(a) Calculate the standard prime cost of one unit of finished product.

(b) (i) Calculate the Sales Budget for each of months 1,2 and 3, in units and in value.

(ii) Calculate the Production Budget for each of months 1, 2 and 3.

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(i) Calculate the Direct Labour Budget in hours for each department for each of
months 1, 2 and 3 and in total.

(ii) Calculate the Direct Labour Budget in K dollars for each department and in total,
for the total of months 1, 2 and 3 only

SOLUTION

(a) Standard Cost Material X 3 * K10 = 30

Y 2 * 20 = 40
Z 1 * 15 = 15
––
85

Labour A 2 * K6= 12
B 2 * 6 = 12
C 3 * 5 = 15
––
K124
(b) (i) Sales Budget

Month 1 Month 2 Month 3

Units 10,000 11,000 10,000

Price K180 K180 K180

Total K1,800,000 1,980,000 1,800,000

(ii) Production Budget

Month 1 Month 2 Month 3

Sales 10,000 11,000 10,000

Closing Stock +1,100 +1,000 +1,200

Opening Stock–1,000 –1,100 –1,000

––––––– ––––––– –––––––

Production 10,100 10,900 10,200

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 ––––––– ––––––– –––––––

(iii) Direct Labour Budget

Month 1 Month 2 Month 3

Quarter 1

Dept A hrs 20,200 21,800 20,400

62,400

Dept B 20,200 21,800 20,400

62,400

Dept C 30,300 32,700 30,600

93,600

(iv) Direct Labour Budget

Department A Department B Department C

Total

Hours 62,400 62,400 93,600

Rate per hour * K6 * K6 * K5

Total K374,400 K374,400 K468,000

K1,216,800

CASH BUDGET.

A cash budget is a 'detailed budget of estimated cash inflows and outflows

incorporating both revenue and capital items'. CIMA Official Terminology.
The cash budget is one of the most important planning tools that an organisation can
use. It shows the cash effect of all plans made within the budgetary process and
hence its preparation can lead to a modification of budgets if it shows that there are
insufficient cash resources to finance the planned operations.
It can also give management an indication of potential problems that could arise and
allows them the opportunity to take action to avoid such problems.

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FOUR POSITIONS OF A CASH BUDGET
A cash budget can show four positions. Management will need to take appropriate
action depending on the potential position.

Cash position Appropriate management action

Short-term surplus
Short-term shortfall
Long-term surplus
Long-term shortfall
Pay suppliers early to obtain discount
Attempt to increase sales by increasing receivables and
inventories
Make short-term investments
Increase accounts payable
Reduce receivables
Arrange an overdraft
Make long-term investments
Expand
Diversify
Replace/update non-current assets
Raise long-term finance (such as via issue of share capital)
Consider shutdown/disinvestment opportunities

EXERCISE

H ltd is preparing its budget for the second quarter. The following information is
available

June July August September

K’000 K’000 K’000 K’000

Sales 12,500 13,600 17,000 16,800

Direct material purchases 3,450 3,780 2,890 3,150

Direct wages are K1, 300,000 per month.

Additional information

(i) H ltd sells 10% of its goods for cash. The remainder of customers receive one
month’s credit.

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 (ii) Payments to creditors are made in the month following purchase.
(iii) Wages are paid as they are incurred
(iv) H ltd takes one month’s credit on all overheads
(v) Production overheads are K3, 200,000 per month.
(vi) Selling, distribution and administration overheads amount to K1, 890,000 per
month.
(vii) Included in the amounts for overhead given above are depreciation charges
of K300,000 and K190,000 respectively.
(viii) The cash balance at the end of June is forecast to be K1, 235,000.
(ix) An asset costing K5, 600,000 will be acquired in September.
(x) H ltd expects to purchase a delivery vehicle in July for K9,870,000
(xi) Capital expenditure is paid one month after being incurred.

Required

(a) Prepare a cash budget for each of the months July to September.
(b) Examine and interpret the cash budget
(c) Explain the importance of budgets and particularly cash budgets in and
organization.

Approaches to budgeting

There are several different approaches to budgeting. These include incremental

budgeting, zero-based budgeting, rolling budgeting and participative budgeting.

Zero-based budgeting

Zero-based budgeting involves preparing a budget for each cost centre from a zero
base. Every item of expenditure has then to be justified in its entirety in order to be
included in the next year's budget.

ZBB rejects the assumption inherent in incremental budgeting that next year's budget
can be based on this year's costs.

Rolling budgets

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As an organisation and the environment it operates in are dynamic (always changing)
management may decide to introduce a system of rolling budgets (also called
continuous budgets).

A rolling budget is a budget which is continuously updated by adding a further

accounting period (a month or quarter) when the earlier accounting period has expired.

Participative budgeting

Participative budgeting is 'A budgeting system in which all budget holders are given the
opportunity to participate in setting their own budgets'. (CIMA Official Terminology

INCREMENTAL BUDGETING

This is a type of budgeting where by the next period’s budget is based on

current years actual results plus allowances for inflation and growth.
Incremental budgeting is a traditional approach to budgeting, widely used in
commercial organizations and the public sector. The traditional approach to
budgeting is to base next year's budget on the current year's results plus an
extra amount for estimated growth or inflation next year. This approach is
known as incremental budgeting since it is concerned mainly with the
increments in costs and revenues which will occur in the coming period.

Activity Based Budgeting

Resource allocation based on relationship between activities and costs, and which
provides greater detail on overheads than the normal financial budgeting.This approach
is related to ABC.

Exercise

(a) It is generally acknowledged that when preparing budgets human behaviour should
be taken into consideration.

Required:

Write notes that

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(i) explain the participative approach to budgeting and identify two advantages and
two disadvantages of such an approach;

(ii) Explain the effect that the level of difficulty built into budget targets can have on
motivation;

(iii) Define goal congruence;

(iv) Explain how a lack of goal congruence can lead to dysfunctional decision-making.

(b) The Clemenza Co is a long established hotel business, which operates 10 luxury
hotels located in capital cities throughout the world. It has an international reputation for
excellence. The company management structure comprises three main board directors
(a chairman, a managing director and a finance director) and 10 hotel general
managers. Recently Clemenza Co appointed a new managing director who, in an
attempt to increase profitability, made the following changes to the company’s
budgeting system:

(i) Budgets for each hotel were to be set by and approved by the managing director and
finance director. Hotel general managers were required to achieve all sales and cost
targets included in the budgets. Previously hotel managers had drafted their own
budgets, which, subject to main board approval, became the budgets for the period.

(ii) Large increases in profitability were required and as a consequence budget targets
became more difficult. This was despite the adverse market conditions faced by hotel
operators around the world.

(iii) Hotel restaurant cost budgets (mainly ingredients and staff costs) were reduced by
20% as compared to previous years. Hotel general managers’ salary packages were
altered to include a large element of performance related pay which was linked to the
achievement of cost budgets.

Required:

Explain three potential problems with the new managing director’s approach to
budgeting.

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QUESTION ONE

Chitoshi Ltd is a small company that manufactures sportswear. Its financial director is
considering setting up a budgeting system. As a starting point he needs to decide on monthly
production levels for the first three months of 2019. However, for the first three months of 2019
production will be constrained by a lack of direct labour.

Because of building works in the factory Chitoshi is unable to carry any month end stock of
finished goods or raw materials in the first quarter of the year. There will be no opening stocks
at the beginning of January.

After the first three months of 2019 direct labour will no longer be a constraint, due to
recruitment of more workers. Building work will also be complete and the firm will once again be
able to carry stock. The company expects to be able to sell 15,000 shirts in April 2019. Sales
volumes are expected to grow at 2% per month cumulatively thereafter throughout 2019. The
following additional information is available.

1. The company intends to carry a stock of finished garments sufficient to meet 40% of the next
month’s sales.

2. The company intends to carry sufficient raw material stock to meet the following month’s
production.

3.Estimated costs and revenues per shirt are as follows:

Per shirt

Sales price 30

Raw materials

Fabric at K12 per square metre (12)

Dyes and cotton (3)

Direct labour at K8 per hour (4)

Fixed overheads at K4 per hour (2)

––––

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Profit K9

––––––––

Required:

Prepare the following budgets on a monthly basis for each of the three months July to
September 2019:

(i) A sales budget showing sales units and sales revenue ; (4 marks)

(ii) A production budget (in units) ; (6 marks)

(iii) A fabric purchases budget (in square metres). (4 marks)

(iv) Labour hours and cost budget (4 Marks)

[Total18 Marks]

SOLUTION

SALES BUDGET

JULY AUGUST SEPTEMBER OCTOBER

Sales (units) 15918 16236 16561 16892

Selling Price 30 30 30 30____

477,540 487,091 496,833 506,773

PRODUCTION BUDGET

JULY AUGUST SEPTEMBER OC

Sales 15918 16236 16561 16,892

Add Closing Stock 6494 6624 6757 6,892

Less Opening Stock 6367 6494 6624 6757

Production 16,045 16,366 16,693 17,027

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 RAW MATERIALS PURCHASES BUDGET

JULY AUGUST SEPTEMBER

Production (1 per unit) 16,045 16,366 16,693

Add Closing stock 16,366 16,693 17,027

Less Opening Stock 16,045 16,366 16,693

Purchases 16,366 16,693 17,027

LABOUR HOURS AND COST BUDGET

JULY AUGUST SEPTEMBER

Production (0.5 per unit) 8,023 8,183 8,347

Rate per hour 8 8 8____

64,184 65,464 66,776

QUESTION TWO

Some commentators argue that: ‘With continuing pressure to control costs and maintain
efficiency, the time has come for all public sector organisations to embrace zero-based
budgeting. There is no longer a place for incremental budgeting in any organisation,
particularly public sector ones, where zero-based budgeting is far more suitable
anyway.’

Required:

(a) Discuss the particular difficulties encountered when budgeting in public sector
organisations compared with budgeting in private sector organisations, drawing
comparisons between the two types of organisations. (8 marks)

(b) Explain the terms ‘incremental budgeting’ and ‘zero-based budgeting’. (4 marks)

(c) State the main stages involved in preparing zero-based budgets. (4 marks)

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(d) Discuss the view that ‘there is no longer a place for incremental budgeting in any
organisation, particularly public sector ones,’ highlighting any drawbacks of zero-based
budgeting that need to be considered.(9 marks) (25 marks)

SOLUTION

(a) Difficulties in the public sector

In the public sector, the objectives of the organisation are more difficult to define in a quantifiable way than the objectives of a
private company. For example, a private company’s objectives may be to maximise profit. The meeting of this objective can then
be set out in the budget by aiming for a percentage increase in sales and perhaps the cutting of various costs. If, on the other hand,
the public sector organisation is a hospital, for example, then the objectives may be largely qualitative, such as ensuring that all
outpatients are given an appointment within eight weeks of being referred to the hospital. This is difficult to define in a
quantifiable way, and how it is actually achieved is even more difficult to define.
This leads onto the next reason why budgeting is so difficult in public sector organisations. Just as objectives are difficult to
define quantifiably, so too are the organisation’s outputs. In a private company the output can be measured in terms of sales
revenue. There is a direct relationship between the expenditure that needs to be incurred i.e. needs to be input in order to achieve
the desired level of output. In a hospital, on the other hand, it is difficult to define a quantifiable relationship between inputs and
outputs. What is more easy to compare is the relationship between how much cash is available for a particular area and how much
cash is actually needed. Therefore, budgeting naturally focuses on inputs alone, rather than the relationship between inputs and
outputs.
Finally, public sector organisations are always under pressure to show that they are offering good value for money, i.e.providing
a service that is economical, efficient and effective. Therefore, they must achieve the desired results with the minimum use of
resources. This, in itself, makes the budgeting process more difficult.
(b) Incremental and zero-based budgeting ‘Incremental budgeting’ is the term used to describe the process whereby a budget is
prepared using a previous period’s budget or actual performance as a base, with incremental amounts then being added for the
new budget period.
‘Zero-based budgeting’, on the other hand, refers to a budgeting process which starts from a base of zero, with no reference being
made to the prior period’s budget or performance. Every department function is reviewed comprehensively, with all expenditure
requiring approval, rather than just the incremental expenditure requiring approval.
(c) Stages in zero-based budgeting
Zero-based budgeting involves three main stages:
1. Activities are identified by managers. These activities are then described in what is called a ‘decision package’. This
decision package is prepared at the base level, representing the minimum level of service or support needed to achieve the
organisation’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 organisation. 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.
(d) No longer a place for incremental budgeting
The view that there is no longer a place for incremental budgeting in any organisation is a rather extreme view. It is known for
encouraging slack and wasteful spending, hence the comment that it is particularly unsuitable for public sector organisations,
where cash cutbacks are being made. However, to say that there is no place for it at all is to ignore the drawbacks of zero-based
budgeting. These should not be ignored as they can make ZBB implausible in some organisations or departments. They are as
follows:
– Departmental managers will not have the skills necessary to construct decision packages. They will need training for this and
training takes time and money.
– In a large organisation, the number of activities will be so large that the amount of paperwork generated from ZBB will be
unmanageable.
– Ranking the packages can be difficult, since many activities cannot be compared on the basis of purely quantitative
measures. Qualitative factors need to be incorporated but this is difficult.

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– The process of identifying decision packages, determining their purpose, costs and benefits is massively time consuming and
therefore costly.
– Since decisions are made at budget time, managers may feel unable to react to changes that occur during the year. This could
have a detrimental effect on the business if it fails to react to emerging opportunities and threats.
It could be argued that ZBB is more suitable for public sector than for private sector organisations. This is because, firstly, it is
far easier to put activities into decision packages in organisations which undertake set definable activities. Local government, for
example, have set activities including the provision of housing, schools and local transport. Secondly, it is far more suited to costs
that are discretionary in nature or for support activities. Such costs can be found mostly in not for profit organisations or the
public sector, or in the service department of commercial operations.
Since ZBB requires all costs to be justified, it would seem inappropriate to use it for the entire budgeting process in a
commercial organisation. Why take so much time and resources justifying costs that must be incurred in order to meet basic
production needs? It makes no sense to use such a long-winded process for costs where no discretion can be exercised anyway.
Incremental budgeting is, by its nature, quick and easy to do and easily understood. These factors should not be ignored.
In conclusion, whilst ZBB is more suited to public sector organisations, and is more likely to make cost savings in hard times
such as these, its drawbacks should not be overlooked.

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