6.

BUDGETING AND BUDGETARY CONTROL

6.0

Learning outcomes

On completion of this chapter you should be able to:

Define the terms budgeting and budgetary control.
Prepare a cash budget.
Explain the advantages and problems in budgeting.
Evaluate budgeting and budgetary control as a system of financial control

6.1

Introduction

This chapter, in the main, deals with the mechanical aspects of budgeting. It examines the
advantages, problems and behavioural aspects of budgeting.
A budget may be defined as :
a financial or quantitative statement prepared in advance of a
specified accounting period.
Budgetary control refers to:
A control technique whereby actual results are compared
with budgets, and any differences (variances) arising are
identified and appropriate control action taken..
Budgeting and budgetary control are therefore concerned with the preparation of budgets,
establishing areas of responsibility and the comparison of actual results with budget. The chapter,
therefore, considers the control and planning functions of the management accountant ,which
ensure that corporate objectives are achieved.
Planning involves estimating costs, determining priorities and allocating resources, in order to
achieve corporate goals.
Budgeting is the detailed decision-making which determines how the resources are to be used.
Both are integrated as a unified system of control.

6.2 Advantages of budgeting and budgetary control

Planning is compelled: formal budget procedures compel management at all levels to think
about the future, and to ensure that the long term corporate plan is achieved.
Promote coordination and communication: information about proposed activities of the
firm is dispersed throughout the organization to all levels of management, and departmental
activities are brought in line with each other.
Areas of responsibility are clearly defined so that costs and revenue can be assigned to
those deemed responsible for them.

 A basis for performance evaluation is provided. Once the budget has been prepared
then it provides a yardstick against which to measure the performance of the firm both in
total and for each of its subcomponents.
Efficient and inefficient areas of the organization are highlighted in the form of favourable
and adverse variances, thereby prompting remedial action where necessary.
Motivation is increased as the budgetary control system encourages participation in the
setting of budgets, gives people more responsibility, and endeavours to align individual
goals with corporate goals.
Improve the allocation of resources and control spending.
Economise on managerial time by using the management-by-exception principle.

6.3

Problems in budgeting
Apathy can exist among the work force; motivation becomes a difficult task if budgets
are seen as pressure devices imposed by management.
Departmental conflict may arise over resource allocation, and because departments blame
each other if targets are not attained.
It is difficult to reconcile personal and corporate goals, as the former continually change
and may be considerably lower than the latter.
Waste is found in budgets when managers adopt the view we had better spend it or we
will lose it. This problem, coupled with empire building in order to enhance the
prestige of a department, can be overcome by using the technique called zero base
budgeting.
Inflation and other uncertainties can cause problems in the system.
There is a problem in linking responsibility with controllability; in other words, costs are
only controllable by the manager within a certain time span, and some costs are under the
influence of more than one person.
Dysfunctional decisions may arise when a manager aims to improve his short-run
performance at the expense of the organization as a whole.
Managers may overestimate costs in order that they will not be blamed in the future
should they over spend.

6.4

Budgets for planning and budgets for control

Normally, budgets for planning are based on what management believes will happen. However,
budgets for control may exclude some items which are not thought likely to happen and may be
based, for motivational purposes, on standards which are likely to reflect actual levels of
achievement. For example, in planning for the effects of a possible strike, the potential effects
will not usually be formalized into the monthly budget allowances of each department.
The main points of similarity and difference between the two types include:
(a) Participation. This is encouraged for control purposes, but not for the planning process.
(b) Comprehensiveness. Planning must embrace the whole firm whereas budgetary control
may embrace only part of it.

(c) Standards. Planning budgets are based on standards of performance which management
believe will exist. Control budgets have a motivational impact and therefore are based on
standards which are likely to influence managerial behaviour in a way which is beneficial
to the firm.
(d) Flexibility. Planning budgets must be flexible to changes in circumstances, and control
budgets to changes in activity levels.
(e) Feedback. This is essential for both types of budgets in order to ensure that standards are
relevant, budgets are feasible and performance is constantly monitored.
(f) Analysis of costs and revenue. Budgets for planning frequently base cost estimates on an
analysis of costs along product lines; budgets for control will analyse the cost into
departments or cost centres irrespective of product lines dealt with.

6.5

Requirements of an effective budgetary control

The following prerequisites are necessary before a system of budgetary control can be
implemented:
(a) Budget centres. These are clearly defined areas of the organization where responsibility
lies for the preparation of budgets; a budget centre may encompass several cost centres.
(b) Budget committee: this is comprised of senior members of the organization (departmental
heads and executives), and has the following purposes:
(i)
gives support to the budgetary control system;
(ii)
reviews budgets;
(iii)
authorizes the master budget;
(iv)
establishes long-term plans;
(v)
reviews actual results compared with budgets.
(c) Budget officer: controls the budget administration; the job involves liaising between the
budget committee and the managers responsible for budget preparation, dealing with
budgetary control problems, ensuring that deadlines are met, and educating people about
budgetary control.
(d) Budget manual. This charts the organization, and details the budget procedures; it
contains account codes for items of expenditure and revenue, and timetables, and takes
the form of a documented rulebook, clearly defining the responsibilities of persons
involved in the budgeting system.

6.6

Types of Budgets and Budget preparation

The first thing to determine when preparing budgets is the limiting or principal budget factor,
that is, the factor that limits activity. It may be demand, material, finance or labour.

6.6.1 Sales budget

The budget is expressed in quantitative and financial terms and will involve a realistic sales
forecast based on the companys pricing policy, general economic and political conditions,
changes in population, competition, consumers tastes and incomes, advertising and other sales
promotion techniques, strength of sales force, after sales service, credit terms offered, etc.

6.6.2 Production budget

The production budget is expressed in quantitative terms only, and is geared to the sales budget.
The production managers responsibilities involve plant utilization and work-in-progress
budgets. If requirements exceed capacity, he may subcontract, plan for overtime or shift work, or
hire or buy additional machinery. On the hand, if requirements are less than capacity then any
spare capacity may be used for any other profitable purposes by management.

6.6.3 Raw materials and purchasing budget

The materials usage budget is in quantities, whereas the materials purchases budget is
quantitative and financial. Factors influencing these budgets include production requirements,
planning stock levels, storage space, and trends of material prices.

6.6.4 Labour budget

This budget is quantitative and financial, and is influenced by production requirements, manhours available, grades of labour required, wage rates and the need for incentives.

6.6.5 Cash budget

The cash budget is a cash plan for a defined period of time. It summarizes monthly cash receipts
and payments, thus highlighting monthly surpluses and deficits.
Its main purposes are:
a) To maintain control over the firms cash requirements, particularly with respect to stock
and debtor levels;
b) To enable a company to take precautionary measures and arrange in advance for
investment and loan facilities where budgeted surpluses and deficits arise;
c) To show the feasibility of managements plans in cash terms;
d) To illustrate the financial impact of changes in management policy, such as a change of
the credit terms offered to customers.

6.6.6

Master budgets

Other budgets that may be prepared include budgets for administration, research and
development, selling and distribution, capital expenditure and working capital (showing changes
in debtors and creditors).
The master budget is the total budget package of a company. It is the end product of the budget
process and encompasses all of the above budgets, once they have been authorized by the budget
committee. The development of the master budget is a sequential process, in which information

from one budget is carried forward to another budget. However, some elements such as the
capital budget are independent. Figure 5.1 below shows a simplified sub-classification of the
master budget.
Figure 6.1

An Simplified Master Budget

Master budget
consists of

Operating budget

Financial budget

consists of

consists of

Budgeted P/L
Sales budget
Production budget
Materials budget
Labour budget
Admin. budget, etc.

Cash budget
Balance Sheet
Cash flow statement

The following example serves to illustrate the actual preparation of all the budgets discussed
above and effort must be made to understand every one of them.

Practice Questions
QUESTION 1
J. K. Limiteds budgeted unit sales for the product Jaxo are as follows for the first half of 2010:
Months:
Units:

Jan
700

Feb
800

Mar
800

Apr
900

May
1000

Jun
1200

Budgeted unit costs are:

Direct Material
Direct Labour
Variable Overheads (other than selling expenses)
Fixed Overheads

$3
$4
$2
$3

Selling Expenses

$3

Jaxo is sold for $25 per unit.

80% of sales are on credit and, of that figure, it is expected that 70% will be paid for during the
month following sale and will be allowed 2 % discount. The reminder of credit customers are
expected to pay in full 2 months after sale. Bad debts are anticipated to be 2% of total monthly
sales. Cash customers are allowed a discount of 3%.
Production each month is planned to meet the following months sales, whilst purchases of direct
material meet the following months production. All suppliers are to be paid in the month after
purchase, to qualify for a 2% discount.
The work force is paid for each months labour during the month of production, and a bonus of
$1 per unit is paid on production over 800 units.
Variable Overheads and Selling Expenses are paid in the month after production.
Annual Fixed Overhead is $33 600, equal amounts being paid each month with the exception of
rent. Rent is paid quarterly, commencing in February each year.
Included in the Fixed Overhead is $12 000 per annum for depreciation and $4 920 per annum for
rent.
New machinery costing $15 000 will be purchased in March. A deposit of 20% is to be paid in
March and the remainder over 12 months in equal interest-free monthly installations beginning
in May.
At the end of February there is a Bank Overdraft of $8 000.

Required:
a)

Draw up a Cash Budget for the months of March, April and May.

b)

Explain why a business would prepare a Cash Forecast. List the steps to be taken if the
Cash Forecast highlights future cash shortages.

QUESTION 2
The following forecasts have been extracted from the books of Nandos Enterprises:
Sales

Purchases
$

Overheads
$

Wages
$

Nov 2013
Dec 2013
Jan 2014
Feb 2014
2014

42 000
26 000
28 000
32 000
38 000

24 000
25 000
14 000
16 000
18 000

4 200
3 200
3 600
3 400
3 800

13 000
9 000
9 600
12 000

Mar

12 000

Additional information:
a)
b)
c)
d)
e)

All purchases are on credit basis and suppliers give 2 months credit.
Seventy-five percent sales are for cash, (the balance being credit sales). Debtors are
expected to settle their accounts in the month following sale.
Wages are paid in the month they are incurred.
The bank balance on 1 January 2014 had been estimated to be $3 600.
Overheads include depreciation of $800 per month and are paid one month in arrears.

Required:
Prepare for Nandos Enterprises the following:
a)

Cash budget for the quarter ending 31 March 2014, and

(19 marks)

b)

Explain why Nandos Enterprises want to prepare a Cash Budget

(6 marks)