Budgeting

AS per CIMA “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. It expresses strategic plans of business units, organizati ons, activities or events in measurable terms”

Budgeting is thus, an important tool for financial planning and control in the organisation.

The budgeting process varies from organisation to organisation on the difference in management style,

organisational objectives, structure of competition, nature of work etc. The following are some of the

common steps to be adopted in building a budget:

1. Obtaining estimates of sales, production levels, expected costs, and availability of resources from each

department – These estimates are obtained from the departmental heads of the company.

2. Coordinating estimates – Various estimates obtained from the different units of an organisation are

evaluated as a whole and future estimates for the entire company are laid down. Upon estimating the

future performance of the company, available resources are allocated among the various activities.

3. Communicating the budget to responsible managers and concerned departments – Approved individual

budgets, are communicated to the concerned managers. Any changes and modifications to the final budget

should be made known to the managers to obtain their support.

4. Implementing the budget plan – The final budget must be properly implemented by all concerned

departments.

5. Reporting progress towards budgeted objectives – As feedback, performance reports are prepared to inform departmental managers and the top management about the targets achieved in relation to the

budgeted figures. Based on the feedback, corrective actions for the future can be taken.

The budget period

The budget period assumes importance for planning an organisation’s future activities. The length of the

budget period depends on the type of business, the length of the business cycle from the raw materials

stage to the finished goods stage or in case of services firm from conception to delivery of services, the ease or difficulty of forecasting future market conditions. Generally companies prepare two ranges of

budgets: short range and long-range.

Short-range budget- Short-range budgets cover around three, six months or one year periods. Manufacturing firms for instance, consider one year as their budget period, while wholesale and retail firms

usually employ a six-month budget period. In determining the period of the short-range budget, the

following factors should be considered:

The budget period must be long enough to cover complete production of various products

For business of seasonal nature, the budget period must cover at least one entire cycle

The budget period must be long enough to allow financing of production well in advance of

actual needs

The budget period must coincide with the financial accounting period to compare actual results

with the budgeted estimates and thus implement corrective plans

Long-range budgets- A long-range budget is defined as a systematic and formalised process for directing and controlling future operations towards a desired objective for periods extending beyond one year. Such

budgets cover specific areas like future sales, production, long-term capital expenditure, extensive

research and development programmes. These budgets help in making correct present decisions and

evaluating future implications associated with present decisions

Several factors such as market trends, economic factors, growth of population, consumption pattern,

industrial production, national income, government, and economic and industrial policy are considered

while preparing long-range budgets. Based on these parameters, the future sales for the company are

forecasted, on the basis of which, projected profit and loss account and the balance sheet are prepared.

These projected financial statements help in guiding the organisation’s activity towards its future

objectives.

Fixed and flexible budgets

Fixed budgets

A fixed budget is defined as a budget, which is designed to remain unchanged irrespective of the level of

activity actually attained. It is based on a single level of activity. Fixed budgets do not change when the level of business activity changes.

In practice however, fixed budgets are rarely used, as the actual output is different from the budgeted

output. In such a case, the budgets cannot be used as a tool of cost control. The performance report prepared on the basis of the budget will be misleading and will not reflect the correct position. For instance,

if the actual production is 12000 units as against the budgeted 10000, the production costs incurred in

reality will be higher than the budgeted figures. Since, fixed budgets do not account for such differences

in production levels or business activity, costs will be projected as going above the budgeted figure. The performance report prepared on this basis shows that the actual costs are higher than the budgeted costs.

Hence the actual picture of business activities is not reflected.

Flexible budgets

A flexible budget is a budget that is prepared for a range i.e. for more than one level of activity. The

flexible budget is also known as a variable, dynamic, sliding scale, step budget. The underlying principle

for a flexible budget is that every business is dynamic and ever changing. Thus, a flexible budget is developed for a range, say 8000-10000 units of production. Under this approach, if the actual production

is 9000 units compared to the projected amount of 10000 units, the manager uses the flexible budget to

project the costs for 9000 units of output in place of the budgeted 10000 units. The flexible budget covers

a range of activity, is easy to change with a variation in production levels, and thus facilitates correct

performance measurement and reporting.

Steps in flexible budgeting

The following steps are involved in developing a flexible budget: -

1. Deciding the range of activity to which the budget is to be prepared

2. Determining the cost behaviour patterns (fixed, flexible, semi-variable) for each element of cost to be

included in the budget

3. Selecting the activity levels in terms of production levels to prepare budgets at those levels

4. Preparing the budget at the pre-determined level of activity

Advantages of flexible budgets

The following are the main advantages of a flexible budget:

Accurate budgeting- Flexible budgets result in the preparation of more accurate budgets. Such

budgets consider the output and accordingly estimate the costs to be incurred at that level of

output

Accurate performance measurement- Flexible budgeting incorporates changes in activity levels and compares actual performance with the budget in terms of output achieved. This facilities more

meaningful comparison and evaluation of performance.

Coordination- Flexible budgeting results in proper coordination between various departments of a

company. For instance, if production is planned in relation to estimated sales, materials and labour

are acquired to meet expected production needs

Control tool- Such a budget acts as a control tool. Comparisons between the budgeted costs (at

the actual production level) and actual costs form the basis for analysing cost variances and fixing

responsibility for the same.