Definition of Budgetary Control and Analysis of Variance

Budget is a detailed plan of operations for some specific futureperiod. It is an estimate prepared in advance of the period to which it applies. It acts as a business barometer as it is a complete programme of activities of the business for the period covered. According to Gordon and shilling law budget may be defined as “a predetermined detailed plan of action developed and distributed as a guide to current operations and as a partial basis for the subsequent evaluation of performance”

Meaning of control: control means “some sort of systematic effortto compare current performance to a predetermined plan or objective, presumably in order to take any remedial action required”

Management control process involves two separate but closelyrelated activities. Namely planning and controlling. Planning means deciding what is to be done and how it is to be done. Control is assuring that desired results are attained. Budget is simply a plan of action hence the technique of budgetary control is an important tool of management control.

Budgetary control is an essential tool of management for controllingcost and maximizing profits. It may be conceived as one of the supreme examples of rationality in management. It is a useful management tool for comparing the current performance with pre-planned performance with a view to attain equilibrium between ends and means, output and effort. It corrects the deviation from pre-planned path through the media of observation, research planning, control and decision making and thus helps performance of future activities in an orderly way. It uncovers uneconomies in operations, weakness in the organization structure and minimizes wasteful spending.

Budgetary control involves the following “

Establishment of budgets

Continuous comparison of actual with Budget for achievement of budgeted figures.

Revision of Budgets in the light of changed circumstances.

Administration of Budgetary control

In a large –sized organization the process of Budgetary control System can be organized in the following lines:

Determination of Objectives: A budget being a plan for theachievement of objectives, it is desirable that same are defined very precisely. The objectives should be written out and the areas of control should be clearly demarcated in order to give clear understanding of the plan and its scope to all those who must cooperate to make it a success.

Establishment of Budget centre: A budget centre is a sectionof the organization of an undertaking defined for the purpose of budgetary control. A budget is prepared for each centre and therefore the budget centre should be properly selected. A budget centre may again consist of a number of cost centre representing different groups of machines.

Introduction of adequate accounting records and their codification: The accounts department gives data required by thebudget department and with the help of it the budget department can make estimates.

Preparation of budget organization chart: Organization chart is amap that depicts the functions and responsibilities of each member of the management and ensures that each one knows his position in the organization and his relationship to other members. It should be supported by written directives concerning the function of the staff members. The organization chart depends up on the nature and size of the enterprise.

Establishment of Budget Committee: In a small business, the CostAccountant is responsible for the preparation of budget, but in large undertaking, a budget committee is appointed for this purpose. The budget committee consists of chief executive or Managing Director, Budget Officer or Director or Controller and Heads of main departments. The chief executive acts as the Chairman and Cost Accountant as its Secretary. The managers of different departments prepare the budget and submit to this committee. The committee makes necessary adjustments, coordinates all the budgets and prepares a Master Budget.

Preparation of Budget Manual: It’s a document or Schedule or RuleBook which sets out the responsibilities of the persons engaged in the preparation routine of forms and records required for budgetary control. This manual lays down the budget programme, specific and general duties of the executives, departmental managers and the budget committee.

Level of activity: It is essential to establish a normal level of activitysince it forms the basis of the budget. Level of activity can be attained by efficient working under the existing condition.

Selection of the Budget period: The period covered by a budget isknown as budget period. The length of the budget period normally depends up on the nature of the plan, circumstances of the business, the control aspect, production period and timings of availability of finance. Most manufacturing concerns use one year as the budget period. For control purposes, the annual totals are divided by 12 to obtain monthly budgets.

Locating the Principle Budget Factor: Budget should be evolvedaround the principle budget factors in business. Every business has its own key factors, which limits the level of activities. These Key factors should be correctly identified and diagnosed. In most of the enterprises, sales (Demand) are normally the key factor. The success of the budgetary control rests on the accuracy of the sales forecast. If the sales figure proves to be in accurate, most of the budget will be affected. Similarly, materials, labour, cash, space, equipment, management etc may also be the key factors.

Determination of Budget Cost Allowance: It is the cost which abudget centre is expected to incur during a given period of time in relation to the level of activity attained by the budget centre.

Implementation of the Budget and recording of actual performance: a copy of the section of the master budget appropriate to each department sphere of activity is issued to the respective heads for execution.

Budget Variance Analysis and Reporting: A variance is thedivergence between any planned result and the actual result measured in monetary terms. A budget variance is the difference between a budgeted figure and an actual figure. The overall variance between a planned cost and an actual cost is usually due to a number of factors. Ascertaining the contribution of each factor to the overall variance is known as variance analysis.

Elements of a Successful Budgetary Control System

The success of the budgeting process in an organization depends up on the following essential elements:

Objectives: All planning requires that objectives have beenestablished since the plan is merely a means to an end, not an end in itself. The objectives are the end.

Knowledge of Cost Behaviour: understanding of the cost pattern ofthe firm is essential and the Cost-volume –profit Analysis is a useful tool to the budgeting exercise because it aids in the understanding cost behaviour.

Accurate Forecasting of Business Activities: Forecasting is aprerequisite in budgeting process. It is not only the starting point but is also critical to the development of an accurate budget. Forecasting can be done regarding activities which are internal and external to an organization. Business firms require competent market researchers to forecast accurately the external factors.

Coordinating Business Activities: budgeting coordinates allindividual budgets in to an integrated plan as each budget has certain implications for the other budgets. There must be coordination between sales, production, purchasing, and personnel budgets.

Budgets are useful in communicating budgetary expectations and goals and in bringing necessary adjustments in organizational activities.

Education: All levels of Management must be educated on theusefulness of the budget and must be taught the part that each must play in planning and control through budgets. This necessitates a continuous training in budgeting methods.

Communicating the Budget: The success of comprehensivebudgeting programme depends on communication of individual budgets to the different units in the organization. The preparation of budget is of no use unless it is made known to the persons for whom it is made.

Acceptance and cooperation: successful budgeting also requiresthat budget should be accepted by the people who must execute them. Budgeting should have the active cooperation of the entire organization.

Reasonable Flexibility: The budgeting programme should containreasonable flexibility. It should also be remembered that too much flexibility and too much rigidity are both undesirable. Because too much flexibility will weaken the cost control and the budget will become in operative. Similarly too much rigidity not permitting reasonable deviations will create problems and restrictions in the implementation of the budget.

Adequate Systems Support: This will come mainly from theaccounting, where it must be ensured that records and procedures are sufficient for the task in hand. Thus the budget should be linked to the accounting system in such a way that the same definition, etc relate to common elements.

Providing a frame work for Evaluation: Budgeting provides a basisto evaluate the performance of different departments. A budget, properly developed, will contain initially organizational goals and expectations and subsequently can be used as an effective evaluation technique.

Budget and its Types

Budgets are an important tool for effective short term planning and control in organizations. An operational budget usually covers one year and states the revenues and expenses planned for that year. It has these characteristics:

It estimates the profit potential of the business unit.

It is stated in monetary terms, although the monetary amounts may be backed up by non monetary amounts ( e.g. Units sold or produced)

It generally covers a period of one year.

It is a management commitment; managers agree to accept responsibility for attaining the budgeted activities.

The budget proposal is reviewed and approved by an authority higher than the one who prepares the budget.

Once approved, the budget can be changed only under specified conditions.

Periodically, actual financial performance is compared to budget, and variances are analyzed and explained.

Flexible Budget

A Flexible Budget is a dynamic budget which is designed to change in accordance with the level of activity. It is also called as variable budget or Sliding scale budget. A budget prepared in a manner so as to give the budgeted cost for any level of activity is known as Flexible Budget. A flexible Budget recognizes the difference in behaviour between fixed and variable expenses in relation to fluctuations in sales or production and changes according to the change in the level of activity. When flexible budget is used budgeted expense are adjusted to the actual activity level before comparing with actual expenses incurred.

The main idea behind the preparation of flexible budget is that for any given volume of business there should be some type of expenditures and that type should be known well in advance to provide assistance for doing the actual expenditures. From the Control point of view, flexible budget is very effective in those business units where frequent changes occur in activities due to market fluctuations, seasonal variations etc.

There are two ways using which flexible budget can be prepared they are

Formula Method.

Multi activity or Tabular Method. Generally following steps are followed in the preparation of flexible budget:

Decide the range of activity to develop a flexible budget.

Determine the cost behaviour- fixed, variable and semi variable to each element of cost.

Select the activity level (generally in terms of output).

Prepare a budget at each activity level.

Benefits of preparing Flexible Budget

Ascertainment of Cost with greater degree of accuracy.

Control over Cost is made possible because it shows what amount of cost must have been incurred for each level of activity.

Management by Exception is possible because only deviations of significant type are taken up to the top management for solution purpose and for taking remedial actions.

Achievement of best results with maximum return is possible because a careful watch is kept on the production, sales, and inventory levels.

Zero Base Budgets

Generally while constructing a functional budget, the previous year’s budget figures will be taken as the base. This is so because previous year’s figures are adjusted for the impact of inflation and for the proposed increase or decrease in the level of activity of the business then are used in the construction of budget for the current year. This practice brings in the inefficiencies of the previous year to the current year hence to streamline the allocation of funds and to control cost a new technique called Zero Base Budgeting came in to existence.

The “Zero-base” means a “nil budget” as the starting point. There is no given base figure for a budget. ZBB originated in USA. A fresh budgeted figure is determined keeping in view the circumstances and the requirements. The basic concept of ZBB is “Starting from Scratch” that is every activity in an organization must be examined and justified, giving consideration to the alternatives and the results are obtained.

Basic Principles underlying the preparation of ZBB

Every budget starts with a Zero base

No previous year figure need to be taken as base for adjustments.

Fresh examination of each activity

Justification of every allocation in the light of anticipated circumstances.

Give due consideration to alternatives.

Benefits of ZBB

Makes planning and controlling activities in an organization more effective and efficient.

Higher degree of Coordination can be achieved at all levels of activities.

Operating efficiency of the firm is greater because responsibility and accountability can be easily pinpointed.

Efficient allocation and optimum utilization of available resources.

Better interpersonal relationship is developed among employees.

Thus ZBB is a Planning, resources allocation and Control tool. According to ZBB system, justification of the expenditure may be required on the basis of the required output. So while ZBB may be applicable to only a portion of the budgeting effort in an organization, those areas to which it is directly applicable are the hardest to plan and control.

Master Budget

The Master budget is the summary budget incorporating all the functional budgets of the firm. Master budget is prepared in the form of an Income statement, starting with Sales Revenue, followed by cost of sales, operating income, non-operating expenses and other income reaching profit before tax and interest and there after arriving at net profit after deducting financial charges and income tax. Master budget requires the approval of Budget Committee to put it in to operation.

Performance Budgeting

Budgeting is a technique which expresses in financial terms the management’s operation and financing the organization for a specific period of time. It is an effective technique that provides for performance appraisal followed by follow-up measures. Performance budgeting aims at evaluation of performance of the enterprise keeping in view the specific and overall objective of the organization. Its main focus is on the contribution of each employee for the attainment of organizational objective in general and short term business objectives in particular. It provides a concrete direction to each employee ad acts as a control mechanism to top management.

The National Institute of Bank Management define the Performance budgeting as “The process of Analyzing, identifying, simplifying ad crystallizing specific performance objectives of a job to be achieved over a period in the frame work of organizational objectives, the purpose and the objective of the job”. The technique is characterized by its specific direction towards the business objectives of the organization. Performance budgeting lay emphasis on achievement of specific goals and in the long run it aims at continuous growth so that the organization can be sensitive, adoptive and avoid rigidities which may hinder its growth.

Performance budgeting involves preparation of performance report. These reports are prepared by comparing the budget with the actual data and reveal the variance. These reports are prepared using the data provided by the accounting system. The head of the each department is vested with the responsibility of preparing Performance budgets. He will do so using the copy of section of the master budget. The periodical reports will be given to the departmental heads that will prepare a summary of all the sectional budgets and give this to budget committee. The purpose of this report is to inform promptly about the deviations in actual and budgeted activity so that the person in charge will take needed actions to correct the deviations.

Analysis of Variance

Variance Analysis

The main aim of any control process is to identify the variation between the actual performance and the standard fixed. In case any deviation is identified between the actual and the standard then it calls for analysis of such variation in order to find the cause for such variation and to suggest some measures for remedial action. Hence variance analysis is a process of analyzing variance by fragmenting the total variance in to smaller identity so that the responsibility for such variance can be pin pointed easily. If the actual is less than the expected then the variance is said to be Favourable and if the actual is more than the expected, then it is called as unfavourable variance. For example if the actual cost exceeds the standard, then it is unfavourable variance, and vice versa. A variance can be either Price variance or volume variance. Different management personnel are entrusted with the responsibility of carrying out variance analysis. During the course of analysis if any individual is identified as responsible for such variance, then it is called Controllable Variance. But in some cases the variation might have occurred due to factors beyond the control of an individual, then it is called as uncontrollable variance.

In order to minimize the occurrence of variance the management must be cautious in the following aspects:

Fix a reliable Standard.

Provide for incidental expenses.

Consider change in the Market situation.

Provide allowances for possible loss of material, machine hour, labour hour etc.

Consider changes in Managerial policies.