16 Budgeting –Purposes, Types, Process and Zero Base Budgeting

Dr. Ashok Kumar

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COURSE OUTLINE

 

 

Introduction

 

Learning objectives

 

Budgets and Budgeting – Meaning and Concept

 

Purpose of Budgeting

 

Characteristics of Budget

 

Types of Budget

 

Components of Budgeting Process

 

Process of Budgeting

 

Advantages of budgeting

 

Disadvantages of Budgeting

 

Auditing

 

Zero Base Budgeting (ZBB)- Meaning

 

♦ Zero Base Budgeting process steps

 

♦ Advantages of Zero Base Budgeting

 

♦ Disadvantages of Zero Base Budgeting Summary

 

Introduction

 

Time and money are scarce resources to all individuals and organizations. The efficient and effective use of these resources requires planning. Planning alone, however, is insufficient. Control is also necessary to ensure that plans actually are carried out. A budget is a tool that managers or planners use to plan and control the use of scarce resources. A budget is a plan showing the company’s objectives andhowmanagement intends to acquire and use resources to attain those objectives. A budget can be made for a person, family, group of people, business, government, country, multinational organization, or just about anything else that makes and spends money. The budgeting process is carried out to identify whether the person or organization can continue to operate with its projected income and expenses. Therefore, the budget should be objective driven which means that the expected revenues and expenditures of each department will ultimately be based on the organizational objectives.

 

Learning Objectives

  1. The students will be able to understand the budgeting process and its purpose in project formulation.
  2. The students will be able to explain the various types of budget.
  3. The students will be able to explain the importance of auditing in project formulation.
  4. The students will be able to understand the importance of Zero Base Budgeting.

Budget and Budgeting – Meaning and Concept

 

Budget

 

A budget is a financial or quantitative statement prepared for a definite period of time.

 

OR

 

A budget is a financial plan that is used to estimate the revenue and expenses over a specified future period of time.

 

OR

 

A budget is a detailed financial plan that quantifies future expectations and actions relative to acquiring and using resources. The first and most important step to effective financial planning is developing and implementing a budget.

 

In order to make effective decisions and coordinate the decisions and actions of the various departments, businesses need to have a plan for profitability. Typically, a business creates a budget annually which, once approved, becomes the Annual Plan (Budget).

 

OR

 

Budgetrefers to a comprehensive plan in writing, stated in monetary terms that outline the expected financial consequences of management’s plans and strategies for accomplishing the organization’s mission for the coming period.

 

OR

 

A budget is a master financial document or a “blueprint for action that set out the expected contribution from the operation or control of an organization in terms of anticipated cash flows or revenues and expected expenditures over a certain period of time.

 

It can be observed from these two definitions by the NIA that a budget essentially is a tool that forms part of the process of an effective management of an organization, especially in planning and control. Budgets induce management to think systematically and plan ahead about the future. They also serve as a device for coordinating the complex operations of the business, and provide a medium for communicating the financial goals of the firm. There is also a simple definition of budget limiting its function only ‘as a medium of resource allocation’. In reality, most organizations viewed budgets as a statement of approved financial and operational resources allocated to each units, activities and investments. Blumentritt (2006) explained that budgeting is the process of allocating an organization’s available financial resources to its units, activities and investments and to monitor the performance of managers and employees.

 

Budgeting

 

Budgeting is the process of preparing the budget.

OR

Budgetingis the process of preparation, implementation and operation of budgets decisions into specific projected financial plans for relatively short periods of time. In other words, budgeting is the process of “translating financial resources into human purposes” (Wildavsky, 1986).

OR

Budgeting is also viewed as a process of identifying, gathering, summarizing and communicating financialinformation of an organization’s future activities.

OR

Budgeting are formal statements of the financial resources set aside for carrying out specific activities in a given period of time. They are most widely used means for planning and controlling the activities at every level of an organization.

 

Budgetary control:

Refers to any management approach that involves settingsome kind of targets, regularly measuring variances betweenthe original targets and actual outcomes, and motivating people to reduce those variances.

 

CHARACTERISTICS OF BUDGET

As stated earlier, a budget is a blueprint for management action. The following are thecommon features of budget:

  • A budget is quantitatively stated: The figures in the budget are expressed inmonetary terms. However, non-monetary information such as units to be sold, units to be purchased and others support the monetary figures.
  • A budget is prepared in advance: A budget must be drawn up beforethe periodto which it refers. Figures produced during or after the period may be important, but they are not part of a budget.
  • A budget relates to a particular period:Generally, the budget is prepared forone year. However, in the case of a seasonal business, there may be two budgets for each year – a slack season budget and a peak season budget.
  • A budget is a plan of action: A budget is a plan because it concerns actions to be taken rather than a passive acceptance of future trends. Planning is the establishment of objectives and the formulation, evaluation andselection of the policies, strategies, tactics and action required to achieve the objectives. Like all plans, budgets seldom turn out to be totally correct predictions of the future. Conditions may change during the budget period, which renders the budgetto be inaccurate. Even so, budget is useful in guiding the actionsof managers.
  • A budget is an estimation or prediction of profit potential:The budget set forth the expenses and revenues planned during the budget period and thereby reveal its profit potential.

Types of Budget:

The budget can be classified into following types:

  • Sales Budget
  • Production Budget
  • Purchase Budget
  • Selling and Distribution cost Budget
  • Administrative Cost Budget
  • Cash Budget
  • Capital Expenditure Budget
  • Master Budget
  1. Sales Budget: The starting point for any business is sales. All the activities of the business are dependent on sales. Therefore, it is necessary to prepare sales budget. Accuracy in sales budget is very important as all the other budgets are based on sales budget. If something goes wrong in sales budget, then other activities are affected.
  2. Production Budget: Another important budget, which is wholly dependent on sales budget, is the production budget. This budget specifies the quantity of goods to be manufactured during the budget period. It also includes the estimated cost for materials and labor etc.
  3. Purchase Budget: the purchase department prepares this budget. Through this budget, the quantity is estimated and is given in the form of purchase budget.
  4. Selling and Distribution cost Budget: This budget includes the total selling and distribution cost to be   incurred in sales budget.
  5. Administrative Cost Budget: This budget includes all the administrative expenses to be incurred during budget period. The Administrative expenses include salaries, transportation, insurances etc.
  6. Cash Budget: The cash budget is prepared to assess the total requirements of cash for the budget.
  7. Capital Expenditure Budget: This budget includes the amount of capital expenditure needed for capital during the budget period.
  8. Master Budget: Master budget is the sum total of all the budgets for the budget period.

Purpose of Budgeting

Budget helps to aid the planning of actual operations by forcing managers to consider how the conditions might change and what steps should be taken now and by encouraging managers to consider problems before they arise. It also helps to co-ordinate the activities of the organization by compelling managers to examine relationships between their own operation and those of other departments. The main purpose of budgeting is:

  • To control resources
  • To communicate plans to various responsibility center’s managers.
  • To motivate managers to strive to achieve budget goals.
  • To evaluate the performance of managers
  • To provide visibility into the company’s performance
  • For accountability -It is a means for Executive Management to gain consensus on how the year’s resources are going to be allocated towards realization of the company’s quantifiable goals for the year.
  • A Goal Setting Exercise.
  • Provides a Metric for Assessing organization’s Performance.
  • Acts as an Approval Process

Components of Budgeting Process

 

To be effective, the budgeting process should have several key components. These are: Clearly Defined Goals, Effective Communication, Management Involvement, Coordination, and Actual Performance Reporting.

  • Clearly Defined Goals

The Financial Goals of the organization need to be defined at the beginning of the process. A typical goal would be for example, revenue growth at 20%, net income growth of 10% and departmental operating expense growth at varying growth levels. Typically, depending on the organization, each division or department has different growth expectations depending on the type of the organizations. The organization’s that have significant research and development activities, for example, usually allocate a larger amount to research and development expenses. The process of developing the goals begins with an analysis of the current year’s performance and an understanding of what relationships exist to revenue, fixed and variable.

  • Effective Communication

In order for the Management Team to be able to translate the Goals into an operating budget, effective communication is imperative. First, a timetable needs to be developed to set expectations and to determine deadlines. A organization meeting to communicate the process is desirable to ensure everyone receives the same message. A budget package is distributed to management with information to help develop budgets. The package should contain a rolling forecast updated with actuals, employee detail for headcount planning, the defined goals with specifics related to each department, a digital worksheet to aid both the development of the budget and any upload or consolidation process, and a financial calendar which includes deadlines and responsibilities.

  • Management Involvement

For the process to be effective, Management buy-in is essential both in the planning process and during the year to monitor and manage actual performance. One purpose of the budgeting exercise is to achieve consensus by everyone even though they are all competing for the same resources. It is not possible for everyone to be able to add all the headcount they desire or spend the amount of money they would prefer. In addition, each department has a different perspective on what is necessary to achieve the company’s goals and the importance of their contribution. By the end of the process, everyone will have had to compromise and should understand where their interests all intersect with the organization’s goals.

  • Coordination

Someone needs to be in charge of the process and drive towards the deadlines. It is common for it to fall within the Chief Financial Officer’s responsibilities. Absent that position, at the direction of the Chief Financial Officer, it usually belongs in the Controller’s responsibilities. Preparing the information for goal setting, creating the worksheets, consolidating the information and being available to facilitate the process are all responsibilities of this position.

  • Actual Performance Reporting

Important to the effectiveness of the process is regular comparison of actual performance to the budget. In addition to the inclusion of budgets in the financial statement comparisons, many decisions should be made with the budget in mind. For example, headcount additions and fixed asset acquisitions should be evaluated if they were not budgeted expenses. Many organizations allow expenditures that were approved in thebudget process but require extensive justification.

 

Process of Budgeting

 

Budgeting is the process of identifying, gathering, summarizing and communicating financial information of an organization’s future activities. The task of budgeting and monitoring of budgets is an ongoing process. Monitoring involves checking the targets, feedback, and so on. The budgeting process involves the following procedures:

  1. Define the objectives of the organization

First, the management tries to set the organizational objectives. These would include identifying the profits, market share and other targets to be achieved. The targets should be realistic that are made studying the potential of the organization and the market situation.

  1. Set production, marketing and financial budget

There are three major functional budgets and each is dependent on the organizational objectives.

  • Production Budget: It is expressed in quantitative terms only and is geared to the sales budget. It involves costs of raw material, direct labor costs, costs of purchasing components, and so on. This is an expenditure-only budget.
  • Marketing Budget: It is a combination of both the income and expenses. It involves revenue from sales forecasted and expenses involved in actualizing the marketing strategy.
  • Financial budget: The financial budget depicts projected cash flow. It helps to identify if the funds are in a proportion to cover the expenses or not. If not, the management can find alternatives to raise additional funds.
  1. Fragmentation of budget: Each of the above stated budget is then broken down, so that there could be different budgets like training budget, sales budget, and so on.
  1. Budget monitoring procedures establishing: As per the business objectives and the internal environment of the business, appropriate budget monitoring procedures must be established.
  1. Identify variances: Any variances in the projected budgets must be identified and responded too.
  1. Feedback: The experience and knowledge achieved while setting the budget for one period must be utilized while deciding on the budget for another period.

Advantages of budgeting

  • It helps to monitor and control operations.
  • It provides a framework of delegation.
  • It creates a sense of responsibility among the managers.
  • It can improve communication systems within the organization.
  • It promotes forward thinking.
  • It also helps in coordination of different departments and align them towards shared objectives.

Limitations of Budgeting

  • It can demotivate employees if they do not get an opportunity to participate in the budgeting process.
  • It is difficult to estimate all the revenues and expenditure in advance.
  • It can result in building perceptions of unfairness.
  • If budgets are inflexible, then it fails to reflect the necessary changes.
  • Budgeting might result in competition among the departments for resources.

Auditing

Auditing means official examination of accounts. It provides feedback information to avoid systems failure and to improve the working of the system as a whole.It is necessary for the management personnel to be aware of the problems related to auditing. The funding agency does not release funds without obtaining the audit utilization certificate. If this certificate is not being obtained, then it may lead to stoppage of the work. And thus, the proper keeping of the accounts and timely auditing is effective for good functioning of the business organization.

 

Zero Base Budgeting (ZBB)

 

Zero Base Budgeting is a system where each function, irrespective whether it is old or new must be justified wholly each time a new budget is made. It requires each manager to give details of the budget from scratch or zero bases as if it were the first ever budget of the organization.

 

Zero Base Budgeting process involve four basic steps:

 

(i) Identification of activities for which budget has to be prepared.

(ii) Analysis of each activity and ranked on the basis of benefits to the organization

(iii) Evaluation and decision to select the activities

(iv) Allocation of resources to each activity

 

Advantages of Zero Base Budgeting

 

  1. It forces to plan each program afresh and to review each expense again
  2. It helps to avoid mistakes and inefficiencies of the past.
  3. It avoids the danger of the budgetary goal overriding the organizational goals.
  4. It permits management a great deal of freedom and flexibilities in allocating resources from year to year.
  5. It allows greater participation in the budgeting process.
  6. Low priority activities can be rejected with greater confidence and without economic loss.
  7. It helps in better focus on organizational objectives.
  8. It provides effective means to cost control.
  9. It helps in the improvement of the productivity.
  10. It saves time of the top management.

 

 

Summary

 

Budgeting  is  the  process  of  identifying,  gathering,  summarizing  and  communicating financial information of an organization’s future activities whereas,a budget is a plan showing the organization’s objectives and how management intends to acquire and use resources to attain those objectives. The budget can be made for a person, family, group of people, business, government, country, multinational organization, or just about anything else that makes and spends money. The budgeting process is carried out to identify whether the person or organization can continue to operate with its projected income and expenses. Therefore, the budget should be objective driven which means that the expected revenues and expenditures of each department will ultimately be based on the organizational objectives.

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