Lesson 1, Topic 1
In Progress

The Basic Framework of Budgeting


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Budgeting is the process of designing, implementing and operating budgets. It is the managerial process of budget planning and preparation, budgetary control, and the related procedures. Budgeting is the highest level of accounting in terms of future which indicates a definite course of action and not merely reporting.

It is an integral part of such managerial policies as long-range planning, cash flow, capital expenditure and project management.

It must be remembered that budgeting is not forecasting. It is true that budgeting does involve some sort of forecasting particularly in sales budget. But the process is physically one of detailed analyses and planning not merely prognosticating future results.

Forecasting is a process of predicting the future state of world, in connection with those aspects of the world which are relevant to and likely to effect on future activities.

Any organized business cannot avoid anticipating or calculating future conditions and trends for the framing of its future policy and decision. Forecasting is concerned with probable events whereas budgeting relates to planned events. Budgeting should be preceded by forecasting, but forecasting may be done for purpose other than budgeting.

Thus, in forecasting an estimate of what is likely to happen is made whereas budgeting is the process of stating policy and programme to be followed in future. Further, forecasting does not connote any sense of control while budgeting is a tool of control since it represents actions which can be shaped according to sweet will so that it can be suited to the conditions which may or may not happen.

In sum, budget is an operating and financial plan spelling out a target which the management seems to attain based on the forecasts made. A forecast denotes some degree of flexibility while a budget denotes a definite target.

Purpose and Objectives of Budgeting:

The overall purpose of budgeting is to plan different phases of business operations, coordinate activities of different departments of the firm and to ensure effective control over it.

To accomplish this purpose, a budget aims at attaining the following objectives:

1. To prognosticate the firm’s future sales, production cost and other expenses in order to earn desired amount of income and minimise the possibility of business losses.

2. To anticipate the firm’s future financial condition and future need for funds to be employed in the business with a view to keeping the firm solvent.

3. To decide the composition of capitalisation to ensure availability of funds at reasonable cost.

4. To coordinate the efforts of different departments of the firm toward the common objectives.

5. To accelerate efficiency of operations of different departments, divisions, and cost centres of the firm.

6. To fix responsibilities of different departmental heads.

7. To ensure effective control over the firm’s cash, inventory, and sales, and

8. To facilitate centralised control over the firm through the budgetary system.

The Budgeting Process:

The budgeting process usually begins when managers receive top management’s forecasts and marketing project objectives for the coming year, along-with a time-table stating when budgets must be completed. The forecasts and objectives provided by the top management represent guidelines within which departments budgets are prepared.

Usually, the work on budgeting begins with the task of estimating sales because the total activity of a firm depends on the sales. Preparation of sales estimate demands assessment of the existing market situation and projection of one’s ideas as to what would be the market position in the ensuing period for which the budget is proposed. Several internal as well as external factors are taken into consideration.

The sales estimate prepared by the marketing manager is then submitted to the budget committee for consideration. The budget committee comprising of the top management carefully considers the forecast in the light of the past results and the estimates of the future as recommended by economists and statisticians and wherever necessary recommends for changes in estimate or if necessary asks for complete restudy and revision.

Upon the recommendation of the budget committee, the President of the organization accords his approval to the sales estimate which then becomes sales budget of the organization. Budget covering selling and distribution expenses accompany the sales budget. The two budgets together give the net sales revenue expected to arrive in the coming year.

After the preparation of the sales budget and selling and distribution cost budget, Production Budget of the firm is prepared. The production budget is based on the production forecasts which are made after taking into consideration sales budget, the maximum and minimum stock of finished goods to be maintained, the plant capacity and availability of various factors of production.

When targeted production for the budget period has been decided, the production budget (expressed in quantities to be produced) can be converted into a Production Cost Budget. Production Cost budget is composed of Materials Cost Budget, Labour Cost Budget and Overheads Budgets.

Materials cost budget shows expected cost of materials required for budgeted production and sales purpose. Determination of material cost involves quantities to be used and the rate per unit. The task of determining the quantities required is that of the production engineering department while the purchasing department has the responsibility of deciding the rate.

Labour Cost Budget prognosticates the direct labour cost expected to be spent on carrying into effect the targeted production. Preparation of this budget requires information regarding the time required to do one unit of work and the wages to be paid for it.

Overheads Budget is a statement of expected overheads (comprising fixed and variable overheads) which the firm will have to incur during the budget period. This budget is prepared based on overhead forecasts of all the departments of the firm.

Once materials cost budget, labour cost budget and overheads budget are prepared, a full production cost budget can be drawn. This budget is generally presented in the form of a cost sheet.

To achieve competitive edge over its rivals on sustainable basis, an organization will have to develop new products or new processes for producing existing products at minimum cost. Thus, the organization must incur expenditure on research and development effort.

Fundamental Principles of Budgeting:

To ensure that budget serves as an effective technique of managerial decision making, certain cardinal principles must be kept in view.

These principles are:

1. Management Support:

Top management’s support and cooperation is essential for successful implementation of the budget. It should take interest not only in setting the targets and finalising the budgets but also constantly monitoring the actual performance to find out the deviations if any and take curative steps, motivate the personnel, and reward the good performers.

2. Employees Involvement:

The budget should be established on the highest possible level of motivation. All levels of management should participate in setting targets and preparing budget. This will result in defining realistic targets.

Participation of employees in budgeting process will not only make them carefully think about the likely development in the forthcoming period and prepare budget accordingly but will also motivate them to strive hard to achieve budget levels of efficiency and activity.

3. Statement of Organizational Goal:

The organizational goal should be quantified and clearly stated. These goals should be set within the framework of corporate objectives and strategies. A well-defined corporate policy and strategy is a pre-requisite for budgeting.

4. Responsibility Accounting:

Individual employees should be informed about expectations of the management. Only those costs over which an individual has predominant control should be used in evaluating performance of that individual. Responsibility reports often contain budget to actual comparisons.

5. Organizational Structure:

There should be well-planned organizational structure with clearly defined authority and responsibility of different levels of management. Role and responsibilities of Budget Committee and its President must be made known to the people in the organization.

6. Flexibility:

If the basic assumptions underlying the budget change during the year, the budget should be restated. This will enable the management to compare the actual level of operations with the expected performance at that level.

7. Communication of Results:

Proper communications systems should be established for management reporting and information service so that information pertaining to actual performance is presented to the concerned manager timely and accurately so that remedial action is taken wherever necessary.

8. Sound Accounting System:

Organization should have good accounting system so as to generate precise, accurate, reliable and prompt information which is essential for successful implementation of budget system.

SELF-CHECK ACTIVITY

  1. Discuss the purpose of budget?
  2. Discuss the budgeting process?
  3. Identify the fundamental principle of budget?