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UNIT 5 Preparation of Budget

Meaning of budget

According to CIMA, London, budget is defined as ‘a financial and/or quantitative statement

prepared and approved prior to a defined period of time, of the policy to be pursued during

that period for the purpose of attaining a given objective. It may include income, expenditure

and the employment of capital.’ in other words, budget refers to a plan covering all the

sectors of operations expressed in monetary and/or quantitative terms for a definite future

period of time. Budget exhibits managerial plans and policies, for the organization as a

whole, or a part thereof, to achieve business goals and objectives in quantitative terms for a

definite future period.

Meaning of budgeting

According to J. Batty, ‘the entire process of preparing the budgets is known as budgeting.’

therefore, the term budgeting refers to the act of preparing budgets. It is the managerial action

of formulating budgets.

Budgetary control

According to CIMA, London, ‘budgetary control is the establishment of budgets relating to

the responsibilities of executives of a policy and the continuous comparison of the actual with

the budgeted results, either to secure by individual action the objective of the policy or to

provide a basis for its revision.’

In other words, budgetary control is a technique of control under which budgets are prepared

at first for all business activities of an organization and actual performances of those business

activities are compared with the respective budgeted data so that remedial measures can be

taken for any adverse deviation from the budget. Therefore, budgetary control refers to the

application of a comprehensive system of budgeting in the organization to assist the

management in the process of its planning, coordinating, controlling and performance

evaluation. It is an effective tool to the management to achieve the business goals and

objectives of the organization.

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Budget process

A budget process refers to the process by which governments create and approve a budget,

which is as follows:

The Financial Service Department prepares worksheets to assist the department head

in preparation of department budget estimates

The Administrator calls a meeting of managers and they present and discuss plans for

the following year’s projected level of activity.

The managers can work with the Financial Services, or work alone to prepare an

estimate for the departments coming year.

The completed budgets are presented by the managers to their Executive Officers for

review and approval.

Justification of the budget request may be required in writing. In most cases, the

manager talks with their administrative officers about budget requirements.

Adjustments to the budget submission may be required as a result of this phase in the

process.

Budget preparation

The government presents its central government budget on Budget Day, the third Tuesday in

September, but preparations commence in October of the previous year when the Minister of

Finance sends budget instructions to the ministries. The ministers then inform the Minister of

Finance of their plans for the coming period by means of policy letters.

In the spring, the Minister of Finance sends a framework letter, asking what setbacks

and windfalls there have been, what additional funding is being requested, whether

spending in one or more of the three sectors (central government, social security and

care) must be reduced or whether spending can be increased (for example to cut taxes

or improve public finances).

In the aggregates letter in April/May, the Minister of Finance informs the ministries

how much can be spent in the coming year.

In June, every ministry prepares a initial draft budget, which is finalized in the

summer months. The Ministry of Finance decides whether the initial draft budgets are

consistent with the coalition agreement, the budget notice and the aggregates letter.

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Budget Memorandum

The Budget Memorandum is prepared at the same time as the draft budgets. It summarizes

the main policy frameworks set out in the individual budgets and discusses the financial and

economic position of the Country.

Central government budget

In August, all the ministries present their final budgets to the Ministry of Finance. Together,

they form the central government budget. Like other Bills, the central government budget and

the Budget Memorandum are forwarded to the Council of State for advice, which is received

in the first week of September.

The ministers respond to the advice in writing. The central government budget and the

Budget Memorandum are then printed so that they will be ready on time. Any amendments

necessitated by the Council of State’s advice and the latest figures are made in the printer’s

proofs. The budget is then ready to be presented on Budget Day.

Budget Day

On behalf of the government, the Minister of Finance presents the central government budget

and the Budget Memorandum to the House of Representatives on Budget Day, the third

Tuesday in September. When he presents the documents, the Minister of Finance gives a

speech on the state of the Dutch economy.

Essentials of Budgetary Control

Budgetary control is not only an accounting exercise, but also a tool of management at all

levels. In organizing a budgetary control system, it is essential to obtain the full co-operation

of each member of the management team. A number of preliminaries will be necessary for

the implementation of a budgetary control system:

1. Organization for Budgetary Control -The proper organization is essential for the

successful preparation, maintenance and administration of budgets. A budgetary committee is

formed which comprises the departmental heads of various departments. All the functional

heads are entrusted with the responsibility of ensuring proper implementation of their

respective departmental budgets.

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The chief executive in the overall charge of budgetary system. He constitutes a budget

committee for preparing realistic budgets. A budget officer is the convener of the budget

committee who co-ordinates the budgets of different departments. The managers of different

departments are made responsible for their Departmental budgets.

2. Budget Officer

The chief executive appoints budget officer. Such budget officer also called is “Budget

Controller or Budget Director”. His rank should be equal to other functional managers. The

Budget officer does not have the direct responsibility of preparing the budgets. The various

functional managers prepare the budgets. His role is that of a supervisor.

The budget officer works as a coordinator among different departments. He continuously

monitors the actual performance of different departments. He determines the deviations in the

budgets and takes necessary steps to rectify the deficiencies, if any. He also informs the top

management about the performance of different departments. The budget officer will be able

to can out his work only if he is conversant with the working of all the departments. He must

have technical knowledge of the business and should also possess accounting knowledge.

3. Budget Committee

A budget committee is formed to assist the Budget Officer. The Budget Officer acts as

coordinator of this committee. The heads of all the important departments are made members

of this committee. The committee is responsible for preparation and execution of budgets.

The members of this committee put up the case of their respective departments and help the

committee to take collective decisions, if necessary. The budget committee is responsible for

reviewing the budgets prepared by various functional heads.

4. Budget Centers

A budget center is that part of the organization for which the budget is prepared. A budget

center may be a department, section of a department, or any other part of the department.

Ideally, the head of every center should be a member of the Budget Committee.

However, it must be ensured that each budget center at least has an indirect representation in

the Budget Committee.

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The establishment of budget centers is essential for covering all parts of the organization

becomes easy when different centers are established. The budget centers are also necessary

for cost control purposes.

5. Budget Manual

A budget manual is a document that spells out the duties and responsibilities of the various

executives concerned with it specialties among various functional areas. A budget manual

covers the following matters:

1. A budget manual clearly defines the objectives of budgetary control system. It also

gives the benefits and principles of this system.

2. The duties and responsibilities of various persons dealing with preparation and

execution of budgets arc also given in a budget manual. It enables the management to

know the persons dealing with various aspects to budgets and provides clarity on their

duties and responsibilities;

3. It gives information about the sanctioning authorities of various budgets. The

financial powers of different managers are given in the manual for enabling

the spending amount on various expenses.

4. A proper table for budgets including the sending of performance reports is drawn so

that every work starts in time and a systematic control is exercised.

5. The specimen forms and number of copies to be used for ore oaring budget reports is

also stated. Budget centers involved should be clearly stated.

6. The length of various budget periods and control points is clearly given.

7. The problem to be followed in the entire system is clearly stated.

8. A method of accounting to be used for various expenditures is also staled in the

manual.

6. Budget Period

A budget period is the length of time for which a budget is prepared. The budget period

depends upon a number of factors. It may be different for different industries. The budget

period depends upon the following considerations:

The type of budget i.e., sales, production, raw material and capital expenditure

budget. A capital expenditure budget may be for a longer period i.e., 3-5 years,

purchase sale budgets may be one year.

The nature of demand for the products.

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The timings for the availability of the finances.

The economic situation of the cycles.

The length of trade cycles.

7. Determination of key Factor

The budgets are prepared for all functional areas. These budgets are interring dependent and

inter-related. A proper co-ordination among different budgets is necessary for budgetary

control to be successful. A factor, which influences all other budgets, is known as “key factor

or principal factor”. The key factor may not necessity remain the same. The key factor

highlights the limitations of the enterprise. This will enable the management to improve the

working of those departments where scope for improvement exists.

Classification/Types of budget

1. On the basis of period.

a. Long term budgets – The budgets are prepared to depict long term planning of the

business. The period of long term budgets varies between 5-10 years.

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The long term planning is done by the top level management, it is not generally

known to lower levels of management. Long time budgets are prepared for some

sectors of the concern such as capital expenditure, research and development, long

term finance etc.,

b. Short term budgets – This budget are generally for 1 or 2 years and are in the form

of monetary terms. The consumer goods industries like sugar, cotton, textile etc.,

c. Current budgets – The period of current budgets is generally of months and weeks.

These budgets relate to the current activities of the business. According to ICWA

London, “current budget is a budget which is established for use over a short period of

time and is related to current conditions.

2. On the basis of flexibility of production

a. Fixed budget – A fixed budget is a financial plan that does not change through the

budget period, irrespective of any changes from the plan in actual activity levels

experienced. A budget which is made without regard to potential variations in

business activity. Such budgeting might be effective for companies with low variable

costs, but otherwise is likely to be inaccurate.

b. Flexible budget - A budget is a plan for the future. Hence, budgets are planning tools,

and they are usually prepared prior to the start of the period being budgeted. However,

the comparison of the budget to actual results provides valuable information about

performance. Therefore, budgets are both planning tools and performance evaluation

tools. The flexible budget is a performance evaluation tool. It cannot be prepared

before the end of the period. A flexible budget adjusts the static budget for the actual

level of output.

3. On the basis of function of coverage.

a. Operating budget – These budgets relate to the different activities or operations of a

firm. The number of such budgets depends upon the size and nature of business. The

commonly used operating budgets are:

i. Sales budget – A sales budget is a valuable tool that gives a direction to a

company with regard to its targeted sales. It helps to improve the profitability of a

company. The company makes a financial plan with regard to the amount of

goods and services that it plans to sell in a year and the price at which the goods

and services are to be sold. This plan is its sales budget.

ii. Production budget - The production budget is actually an estimate of production

for that budget period. The production budget is actually the initial step in

budgeting production operations. Additionally to production budget, you can find

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three other budgets associated with manufacturing activities of an organization.

These are labor budget, raw materials budget and production overhead budget.

iii. Cost budget - Financial plan prepared for every major expense category, such as

administrative cost, financing cost, production cost, Financial plan based on cost

of the goods and services to be received during a certain period, whether paid or

not during that period. See also expenditure based budget.

Material budget- Direct materials budget is prepared after computing production

requirements by preparing a production budget. Direct materials budget or

materials budgeting details the raw materials that must be purchased to fulfill the

production requirements and to provide for adequate inventories.

Labour budget - Labour budget deals with the cost management or estimation

with the employees and labours working within the boundaries of an organization

with the details of project carried out. The labour cost are directed two ways i.e.,

Direct cost: here it is cost of wages, salaries, commissions, etc ...

Production overhead budget - A manufacturing overhead budget contains all the

costs, other than raw materials and labor, which will be incurred by a

manufacturing company or department during a fiscal year. These ongoing costs

are a valid part of manufacturing expenses you incur and should be calculated as

part of your manufacturing budget. Review the elements that make up

manufacturing overhead to make sure you are counting these in your

manufacturing overhead budget.

Administration budget - An administrative budget is usually prepared on an

annual or quarterly basis and identifies the costs of running an operation that are

not tied to producing a product or service. Costs can include those associated with

non-production and supervisory payroll, depreciation, amortization, consulting,

sales, dues and fees, legal fees and marketing, rent and insurance. The budget

enables management to exercise control of the day-to-day activities of the

business.

Selling and distribution budget - The selling and administrative expense budget

is comprised of the budgets of all non-manufacturing departments, such as the

sales, marketing, accounting, engineering, and facilities departments. The selling

and administrative expense budget is typically presented in either a monthly or

quarterly format. It may also be split up into segments for separate sales and

marketing budget and a separate administration budget.

Research and development budget - The Office of Science and Technology

Policy (OSTP) has responsibility, in partnership with the Office of Management

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and Budget (OMB). OSTP also has responsibility—with the help of the National

Science and Technology Council (NSTC), which is administered out of OSTP—

for coordinating interagency research initiatives. It is OSTP’s mission to help

develop and implement sound science and technology policies and budgets that

reflect Administration priorities and make coordinated progress toward important

national policy goals.

b. Financial budget – Financial budget are concerned with cash receipts and

disbursements, working capital, capital expenditure, financial position and results of

business operation.

i. Cash budget - The cash budget is probably the most important and among the last

to be prepared. It is actually a detailed estimate of money receipts from all sources

and cash payments for many purposes and the resultant cash balance throughout

the budget period. It makes certain how the business has enough cash available to

meet its wants as and when these come up.

ii. Capital expenditure budget - Funds used by a company to acquire or upgrade

physical assets such as property, industrial buildings or equipment. This type of

outlay is made by companies to maintain or increase the scope of their operations.

These expenditures can include everything from repairing a roof to building a brand

new factory.

c. Master budget – Various functional budgets are integrated into master budget. This

budget is prepared by the ultimate integration of separate functional budgets. The

master budget summarizes projected activity by way of a cash budget, budgeted

income statement and budgeted balance sheet. Master budgets are generally used in

larger business to keep many managers on the same page.

Cash Budget

The cash budget is probably the most important and among the last to be prepared. It is

actually a detailed estimate of money receipts from all sources and cash payments for many

purposes and the resultant cash balance throughout the budget period. It makes certain how

the business has enough cash available to meet its wants as and when these come up.

It is a device for controlling and coordinating the financial side from the business to make

sure solvency and give a basis for financing and planning necessary to cover up any

deficiency in cash. Cash budget therefore plays a significant role in the financial management

of any business undertaking.

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Purposes: The principal purposes of cash budget are outlined below:

1. It ensures that sufficient cash is available when required.

2. It indicates cash excesses and shortages so that action may be taken in time to invest any

excess cash or to borrow funds to meet any shortages.

3. It establishes a sound basis for credit

4. It shows whether capital expenditure may be financed internally

5. It establishes a sound basis for control of cash position.

Preparation of Cash Budget

There are three methods of preparing cash budget:

1. Receipts and Payments Method.

2. Adjusted Profit and Loss Method and.

3. Balance Sheet Method.

This method is usually used for short term cash forecast arid is much more detailed than the

other two methods.

The cash budget starts with the opening balance of cash at bank and in hand. To this is going

to be added the estimated cash receipts from different sources and from this can be deducted

each estimated payments of cash, whether on capital or revenue account. The resultant figure

is actually dosing cash balance.

Cash receipts in many situations comes from cash sales, collections from debtors, loans and

interest on investments, miscellaneous sources and sale of capital assets. When it comes to

credit sales, adjustment needs to be made for the time lag between the realization of cash and

point of sale. Cash payments are created for raw material purchases, out of pocket expenses,

direct labor, dividends, capital expenditure projects, and so on. The period of credit

appropriate for the payment concerned has to be taken into account.

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Flexible Budget

A budget is a plan for the future. Hence, budgets are planning tools, and they are usually

prepared prior to the start of the period being budgeted. However, the comparison of the

budget to actual results provides valuable information about performance. Therefore, budgets

are both planning tools and performance evaluation tools.

Usually, the single most important input in the budget is some measure of anticipated output.

For a factory, this measure of output is the number of units of each product produced. For a

retailer, it might be the number of units of each product sold. For a hospital, it is the number

of patient days (the number of patient admissions multiplied by the average length of stay).

The static budget is the budget that is based on this projected level of output, prior to the

start of the period. In other words, the static budget is the “original” budget. The static

budget variance is the difference between any line-item in this original budget and the

corresponding line-item from the statement of actual results. Often, the line-item of most

interest is the “bottom line”: total cost of production for the factory and other cost centers; net

income for profit centers.

The flexible budget is a performance evaluation tool. It cannot be prepared before the end of

the period. A flexible budget adjusts the static budget for the actual level of output. The

flexible budget asks the question: “If I had known at the beginning of the period what my

output volume (units produced or units sold) would be, what would my budget have looked

like?” The motivation for the flexible budget is to compare apples to apples.

The flexible budget variance is the difference between any line-item in the flexible budget

and the corresponding line-item from the statement of actual results.

The following steps are used to prepare a flexible budget:

1. Determine the budgeted variable cost per unit of output. Also determine the

budgeted sales price per unit of output, if the entity to which the budget applies

generates revenue (e.g., the retailer or the hospital).

2. Determine the budgeted level of fixed costs.

3. Determine the actual volume of output achieved (e.g., units produced for a

factory, units sold for a retailer, patient days for a hospital).

4. Build the flexible budget based on the budgeted cost information from steps 1 and

2, and the actual volume of output from step 3.

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Flexible budgets are prepared at the end of the period, when actual output is known.

However, the same steps described above for creating the flexible budget can be used prior to

the start of the period to anticipate costs and revenues for any projected level of output, where

the projected level of output is incorporated at step 3.

If these steps are applied to various anticipated levels of output, the analysis is called pro

forma analysis. Pro forma analysis is useful for planning purposes. For example, if next

year’s sales are double this year’s sales, what will be the company’s cash, materials, and

labor requirements in order to meet production needs?

Production Budget

The production budget is actually an estimate of production for that budget period. It is very

first drawn up in amounts of each product and when the leftover budgets have been ready and

cost of production calculated, next the quantities of manufacturing cost are translated into

cash terms, what in impact becomes a production cost budget.

The production budget is actually the initial step in budgeting production operations.

Additionally to production budget, you can find three other budgets associated with

manufacturing activities of an organization. These are labor budget, raw materials budget and

production overhead budget.

Factors: The principal considerations involved in budgeting production are:

1. Sales budget - When sales is the principal budget factor, the production budget will be

based on the volume of sales forecast by the sales budget.

2. Inventory policy - The management decision regarding quantities needed is stock at all

times to meet customer requirements is an important factor.

3. Production capacity - The production capacity of every department needs to be worked

out and budget figures must be within these limits.

4. Management policy - Production policy from the management plays a significant role in

budgeting production. For instance, management might decide to purchase a particular

component part through outside instead of manufacturing it. This can influence production

budget.

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Production Cost Budget

This budget shows the estimated cost of production. The production budget (explained

above) shows the quantities of production. These quantities of production are expressed in

terms of cost in production cost budget. The cost of production is shown in detail in respect

of material cost, labor cost and factory overhead. Thus Production Cost Budget is based upon

Production Budget, Material Cost Budget, labor Cost Budget and Factory Overhead Budget.