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Week 10 and 11 - Budgeting and Budgetary Control..SS2020

MOD 6000: Managerial Accounting for Non-Accountants
Budgeting & Budgetary Control
1. Explain the nature and purpose of budgets
2. Appreciate the difficulties encountered in
preparing budgets
3. Understand the concept of the master budget
and the budget manuals
4. Appreciate the role of the budget holders in a
business organization
5. Describe various types of budgets.
6. Explain the concept of Zero-Based and
Activity Based Budgeting
1. Nature and Purpose of Budgets.
2. Challenges in Budgeting.
3. Master Budget.
4. Budget Manual.
5. Types of Budgets.
6. Zero-Base Budgeting.
7. Activity Based Budgeting.
What is a Budget?
A statement, expressed in monetary terms
indicating how the business resources are to
be deployed.
Business resources:
human resources.
Business plans are usually made in terms of
physical units such as number of units to
produce, number of hours to work amounts of
materials to be consumed and so on.
Aspects of Budgeting
1. Involves future (forecasting).
2. Prepared for a specific period called the budget
period. The budget period should be reasonable to
allow budgetary control.
3. Prepared for departments or functions.
4. Are the basic financial plans.
5. Involves responsibility accounting.
6. Implemented by the departmental heads. Different
budgets in the organization are interrelated.
7. Are often affected by “key” or limiting factors.
Reasons for Budgeting
1. Scheduling of resources.
2. Medium of communication for organizational
plans and objectives.
3. Helps
departments and functions.
4. Motivation element.
5. Helps in Management by Exception.
6. Enables budgetary control.
7. Leads to reduced costs and greater efficiency.
8. Performance evaluation.
Responsibility accounting
- A system of accounting that separates revenues and costs in to
areas of personal responsibility in order to monitor and assess
the performance of each part of an organisation
- A responsibility center is a function or department of an
organisation that is headed by a manager who has direct
responsibility for its performance
- The manager must:
(i) Know what his or her resources are
(ii) The rate at which the resources are consumed in operations
(iii) How well the resources are used
Responsibility Centers
Cost centers, profit centers and investment centers.
- Decisions need to be made on the level of details that
is provided and the frequency of generation of
- Cost benefit of information must also be established
- A control system is desirable to ensure that actual
performance is checked against the budgets
Types of Responsibility Centers
Revenue Centers
 Accountable for revenues only.
 To have validity in planning and control, the
revenue center managers should have control over
how revenues are raised.
 Managers are evaluated on the basis of actual
sales or orders booked against budgets or quotas
 Example: a unit of a chain store in a mall.
Cost Center
- A collecting place for certain costs before they are
analyzed further
- May include a department, machine, group of
machines, project or product
- Each cost center is assigned a cost code in which
direct costs are charged and indirect costs
apportioned to it
- The idea behind cost centers is to hold managers
accountable for the costs.
- Eg R&D, Marketing.
Profit Center
- A unit of an organisation to which both revenues
and costs are assigned so that profitability of the
unit may be measured.
- Differs with a cost center in that it accounts for
both costs and revenues
- Managers must have control of both costs and
- It is possible to have several cost centers in one
profit center
Profit Center….contd
 e.g. departmental stores of larger chains – Wal
Mart, restaurants, corporate hotels such as
 The store manager will have responsibility for
pricing, product selection and promotion.
Investment Center
 This is a profit center whose performance is
measured by its return on capital employed
 Investment center manager must have control
over the investment policy of his department
 Several profit centers may share the same capital
items and so investment centers are likely to
include several profit centers
 Key ratios include; profit to sales ratio, asset
turnover ratios, cost to sales ratios and cost
Wrap up on Responsibility Accounting
 All responsibility centers evolve from the concept of
 Controllability principle states a manager should be assigned
responsibility for the revenue, costs, or investment that (s)he
could control.
 Revenues, costs, or investments that do not fall under a
manager’s control must be excluded when evaluating the
manager or his/her center.
 Problem with this concept: In most organizations, many
revenues and costs are jointly earned or incurred and
differentiation the controllable from the uncontrollable is
An alternative to “Controllability”
 Some argue that performance measures should be
chosen to influence decision-making behavior.
 For example, if market prices for raw material is
increasing, what can a manager do?
 Perhaps, enter into long term contract for fixed
prices for raw materials.
 If electricity consumption cost is going up, find out
how consumption can be economized (better
machines, lighting, reduce waste).
Challenges in Budgeting
1. Too much reliance on the technique as a substitute for
good management.
Affected by factors beyond the control of the firm.
May cause antagonism and decrease motivation.
Budgetary variances may not necessarily relate to poor
managerial performance.
Inflexibility of operations.
Top managements’ interference.
Expensive and time-consuming process.
8. Requires participation of all the concerned persons.
Conditions for Effective Budgeting
1. Top management involvement.
2. Clear-Cut objectives of budgeting.
3. Organization structure with clearly
defined responsibilities.
4. Genuine and full involvement of the
line managers.
5. Appropriate
information system,
Conditions continued…
6. Revise budgets and targets to suit the
changing conditions.
7. Administer budgets in a flexible manner.
8. Constant monitoring of the budget by
comparing actual results and budget
9. Create Budget Centers.
10. Prepare and maintain budget manuals.
11. Make use of Budget Committees.
Budget Making Process
1. Budget Committee.
2. Derive the key forecasts.
3. Prepare quantity budgets.
4. Produce financial budgets.
5. Produce the master budget.
6. Submit budget for approval.
7. Publish the budget.
8. Implement.
9. Budgetary control.
Types of Budgets
1. Sales (Revenue) Material Budgets (Quantity &
2. Production
3. Labour
4. Capital Expenditure
5. Cash
6. Service (utility)
Zero Base Budgeting (ZBB)
A method of budgeting whereby all activities are re-evaluated
each time a budget is formulated. Each functional budget starts
with the assumption that the function does not exist and is at
zero cost.
Increments of cost are compared with increments of benefit,
culminating in the planning maximum benefit for a given
budgeted cost.
Can be applied in the manufacturing firms, profit making as well
as non-profit making organizations to control service
Why ZBB?
Results to more efficient allocation of resources.
2. Focuses attention on value for money by relating
inputs with outputs.
Develops a questioning attitude and makes it easier to
identify inefficient, obsolete or less cost effective
Leads to greater staff and management knowledge of
the operations and activities of the organizations and
can increase motivation.
It is a systematic way of challenging the status quo
and obliges the organization to examine alternative
activities and existing cost behavior patterns and
expenditure levels.
It can be used where no past cost data exists.
ZBB Limitations
Time consuming process.
Generates a lot of paperwork especially for the decision
There is considerable management skill required in
both drawing up the decision packages and for the
ranking process.
ZBB is not always acceptable to staff or management or
trade unions who may prefer the status quo.
Political pressures within organizations also contribute
to the problem of ranking.
It may emphasize short-term benefits to the detriment of
longer term ones, which in the end may be more
Activity Based Budgeting
A method of budgeting in which the activities that incur costs in
every functional area of an organization are recorded and their
relationships are defined and analyzed.
Activities are then tied to strategic goals, after which the costs of
the activities needed are used to create the budget.
ABB begins by looking at results and the activities that created
them, as opposed to cost-based budgeting, which often begins
with raw input and material and works outward.
ABB can also help firms create more accurate financial forecasts.
Approaches to budgeting
Two approaches to budgeting – Top-down
(imposed) and Bottom up (participatory)
Top down – A budget allowance that is set without
permitting the ultimate budget holder to have the
opportunity to participate in the budgeting
Top Down Effective?
1. Newly formed organisations
2. Very small organisations
3. During periods of economic hardships
4. When operational managers lack budget skills
5. When the organisation’s different units require
precise coordination
Top Down Approach - Merits
1. Strategic plans are likely to be incorporated in to
the planned activities
2. They enhance coordination between the plans and
objectives of the departments
3. They use senior managers awareness of total
resource availability
4. They decrease the input from inexperienced or
uninformed lower level employees
5. They decrease the time required to prepare
1. Dissatisfaction, defensiveness and low morale
amongst the employees
2. Feeling of team spirit is eroded
3. The acceptance of organizational goals and
objectives could be limited
4. Feeling of the budget as a punitive device could
5. Heightens political “tensions” in the organisation
6. Does not provide opportunity for lower managers
to learn
Participative budgeting – bottom up
- Also referred to as self imposed budgeting.
- A budgeting system in which all budget holders
are given the opportunity to participate in setting
their own budgets
- Budgets are developed by low level managers who
then submit to top management for approval
Advantages of participative budgets
1. Based on information from employees who are familiar with the
operations on ground
2. Knowledge spread amongst the people
3. Morale and motivation is improved
4. They increase operational managers commitment to organisation
5. Are more realistic
6. Coordination between units is improved
7. Specific resource requirements are included
8. Senior manager overview is combined with operational level details
9. Individual manager’s aspiration levels are taken in to account
Disadvantages – participative budgets
1. They consume more time
2. Changes implemented by senior management
may cause dissatisfaction
3. Not effective if managers are not competent to
make the budgets
4. Can support empire building by subordinates
5. May have slacks
Negotiated Style of Budgeting
A budget in which allowances are set largely on
the basis of negotiations between budget holders
and those to whom they report
- A compromise between the imposed and
participative approaches
1. Budgets are the basic financial plans.
2. Budgets show how financial resources will be
deployed in the future.
3. The budget making process should be orderly
and participative.
4. Budgets are affected by limiting factors
(constraints). Appropriate research should be
done to reveal the extent and impact of these
5. Different organizational budgets are integrated
into the master budget.
6. Activity based budgeting involves paying
attention to the cost and revenue drivers.
7. Zero Based Budgeting does not make use of past
cost information. Rather every items’ inclusion
in the budget is justified by the manager