Unit 1

Introduction to Management Accounting

WHAT IS MANAGEMENT ACCOUNTING?

Managerial accounting, also called management accounting, is a method
of accounting that creates statements, reports, and documents that help
management in making better decisions related to their business'
performance. Managerial accounting is primarily used for internal
purposes.

DEFINITION OF MANAGEMENT ACCOUNTING

According to R.N. Anthony - “Management accounting is concerned with
accounting information that is useful to the management.”
The Institute of Cost and Management Accountants, London, has
defined Management Accounting as: “The application of professional
knowledge and skill in the preparation of accounting information in such a
way as to assist management in the formulation of policies and in the
planning and control of the operation of the undertakings.“
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NATURE (CHARACTERISTICS) OF MANAGEMENT ACCOUNTING
1. It Focuses More on the Future
It is concerned with the nature of management accounting regarding the
future. The management can foresee and plan their future course of
action with its assistance.
2. Methods of Selective Nature
It is a method with a selective focus. It considers only data from the profit
and loss account and balance sheet, which is relevant and valuable to the
management.
3. It demonstrates the causality of events (cause and effect
analysis)
On the profitability of the company, the impact of numerous decisions,
including pricing, advertising a new product, sales mix, cost control, etc.,
is studied. As it shows that the nature of management accounting
establishes the cause and effect relationship.
4. It Provides information and not Decisions
The management accountant never takes any decisions but only provides
data based on which the management takes decisions. The nature of
management accounting shows that it only provides information to the
administration.
5. Use of Special Methods and Concepts

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Some techniques included ration analysis, budgetary control, cash flow
statement, etc. The methods used will depend upon the nature of the
problem and the prevailing circumstances.
6. No set formats
It does not provide information in a prescribed proforma like that of
financial accounting. It includes information that may be more suitable for
the management in making various decisions. There are no set formats for
providing information on the nature of management accounting.
7. No Specific Rules Followed
No specific rules are followed, like management accounting. Though
management accounting tools are the same, their use differs from one
form to another.
8. Purely Optional
It is purely a voluntary technique, and there is no statutory obligation. Its
adoption by a firm depends upon its utility and desirability.
9. Providing Accounting Information
Management Accounting is a service function. it collects data from
financial accounting and cost accounting, analysis it and hence provide it
to different levels of management.
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SCOPE OF MANAGEMENT ACCOUNTING

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Management accounting covers a wide range of areas, such as
financial accounting, cost accounting, budgeting, and taxes. The
primary goal is to assist management in performing its planning,
directing, and managing tasks.

1. Cost Accounting
Cost accounting is a crucial accounting technique because it
provides cost analysis tools for a business, such as marginal cost,
operational cost, inventory costing, budget control, etc. These
are required by business management to draft and outline the
business needs.
Cost accounting assists in determining the total budget for any
firm and gives several methods for estimating and calculating the
entire cost of providing a service to the consumer.
2. Financial Accounting
Financial accounting and cost-accounting are not the same
things. As mentioned earlier, cost accounting involves calculating
and analyzing the overall cost of a business process. Conversely,
financial accounting calculates and analyses business
transactions, including expenses, inventories, assets, and
reporting.

As financial accounting deals with the historical data,

management can better forecast, and operate successfully based
on this data.
3. Budgeting and Forecasting
Forecasting and budgetary controls controls the activities of the business
through the operations of budget by comparing the actuals with the
budgeted figures, and hence finding out the deviations, and analysing the
deviations in order to take suitable remedial action.
4. Financial Administration
The purpose of considering financial management as managerial
accounting in terms of scale is to optimize a company's profits through
the efficient use of cash.
5. Management Reporting/Reporting
Reporting is essential for each business manager. Obtaining reports on
time is critical for managing corporate growth and resources. The timely
report assists management in making successful decisions and keeps
management informed of ongoing operations. Data and reports are
presented to management in simple graphs, charts, and presentations.
6. Data Interpretation
Data interpretation is described as converting business data into facts and
statistics that business management can easily understand. Interpreting

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your work is just as crucial to your business as financial reporting because
it helps you avoid drawing erroneous conclusions from your business data.
7. Inventory Control
Inventory control refers to exercising control over the utilization of raw
materials, processing of work in progress and disposal of finished goods
for a specific period.
8. Taxation
It includes the computation of corporate income tax in accordance with
the tax laws, filing of returns and making tax payments.
9. Internal Audit
Internal audit is conducted by the business organization with the help of a
paid employee who has thorough accounting knowledge. All the relevant
records are maintained under the management accounting system so that
the internal audit is conducted in an effective manner.
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OBJECTIVES (or ROLE) OF MANAGEMENT ACCOUNTING

The fundamental objective of management accounting provides

information to the managers for use in planning, controlling operations,
and decision making.

Main purpose and objectives of management accounting may be

summarized as under:

1. Assistance in planning and formulation of future Policies:

Planning is deciding in advance what is to be done. It helps the

management for effective planning. It provides costing and statistical data
to be utilized in setting goals and formulating future policies.

2. helps in Decision Making

All management work is accomplished by decision making.

Decision making is defined as the selection of a course of action from

among alternatives. It helps the management in decision-making. It uses
accounting data to solve various management problems.

3. helps in Motivating the employees

By setting goals, planning the best and economic courses of action, and
also by measuring the performances of the employees, it tries to increase
their efficiency and, ultimately, motivate the organization as a whole.

4. helps in Controlling performance

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Management accounting helps management in controlling the
performance of the organization. Actual performance is compared with
operating plans, standards, and budgets, and deviations are reported to
the management so that corrective measures may be taken.

5. helps in coordinating operations

Management accounting helps the management in co-ordinating the
activities of the concern by getting prepared functional budgets in the first
instance and then co-ordinating the whole activities of the concern by
integrating all functional budgets into one master budget.

6. Helps in timely Reporting of financial information

One of the primary objectives of management accounting is to keep the

management fully informed about the latest positions of the concern. The
facilitates management to take proper and timely decisions.

7. Assisting with the Understanding of Financial Data

Management accounting focuses on analysing and interpreting data,
which has opened up new avenues. It is concerned with keeping records
of past accomplishments, maintaining values, establishing duties, and
providing a foundation for helping future development.
8. Helpful in Resolving Strategic Problems
Decision-making is largely a management activity. Accounting assists
managers in making effective business decisions. These decisions may
pertain to business expansion, contraction, diversification, or
establishing a new line of business. All of these issues are addressed by
management accounting.

Management accounting uses accessible accounting statistics to solve a

variety of management difficulties. Its purpose is to offer vital facts, not to
make decisions. It simply informed management and delegated decision-
making authority to them.
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FUNCTIONS OF MANAGEMENT ACCOUNTING

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[1] Planning
Proper planning can help to achieve the underlying objectives of
an organisation. Management accounting is entwined in planning
and forecasting so closely by providing reports and information
for decision making.
These reports and information provided by management
accounting help business leaders estimate the effects of
alternative actions to achieve the desired goals.
[2] Decision Making
Selecting among competitive alternatives in a business is
Decision making.To make the best decision for an organisation,
statistical data and accounting information needs to be well
furnished.
Management accounting applies analytical information regarding
various alternatives to make it easy for management to make
decisions. For example, variance analysis, comparing costs vs
budget, computing burn rate, cashflow forecasts and projections,
scenario building, what if analysis and list goes on.
[3] Organising
In order to achieve business goals, it is important to have a
proper organisational framework. With the help of reports and
information provided by management accounting, an organisation
can regulate or adjust its operations and activities in the light of
changing condition.
[4] Controlling
The control and performance reports provided by management
accounting can highlight actual and expected performances of a
business. These reports can be key components in making
necessary corrective action to control operations.
If there comes out differences between budgeted and actual
results, a manager will investigate to know what is going wrong
and possibly.
[5] Financial Statement Analysis
Financial statement analysis is the process of evaluating financial
data such as balance sheet, cash flow statement, income
statement etc. This helps in understanding the financial position
and operating performance of an organisation.
It also helps in forecasting the future condition and performance
of the organisation.
[6] Communication
Management accounting is a crucial medium of communication.
Different levels of management need different types of
information.

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The top management requires information at long intervals,
middle management requires it regularly, while lower
management requires knowledge at short intervals but a detailed
one. Management accounting act as a communicating body within
the organisation and with the outside world provides the needy
information on time.
[7] Coordinating
Management accounting provides various coordination tools such
as budgeting, financial analysis, interpretation, financial
reporting etc. to maximise profit and increase efficiency.
It helps the management by reconciling the cost and financial
accounts, preparing budgets and setting the standard costs and
analysing variances in costs to facilitate management by
exception.

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IMPORTANCE (ADVANTAGES) OF MANAGERIAL ACCOUNTING

The main objective of managerial accounting is to assist the management
of a company in efficiently performing its functions: planning, organizing,
directing, and controlling. Management accounting helps with these
functions in the following ways:

1. Provides data: It serves as a vital source of data for planning. The

historical data captured by managerial accounting shows the growth of
the business, which is useful in forecasting.

2. Analyzes data: The accounting data is presented in a meaningful way

by calculating ratios and projecting trends. This information is then
analysed for planning and decision-making. For example, you can
categorise purchase of different items period-wise, supplier-wise and
territory wise.

3. Aids meaningful discussions: Management accounting can be used

as a means of communicating a course of action throughout the
organization. In the initial stages, it depicts the organisational feasibility
and consistency of various segments of a plan. Later, it tells about the
progress of the plans and the roles of different parties to implement it.

4. Helps in achieving goals: It helps convert organizational strategies

and objectives into feasible business goals. These goals can be achieved
by imposing budget control and standard costing, which are integral parts
of management accounting.

5. Uses qualitative information: Management accounting does not

restrict itself to quantitative information for decision-making. It takes into

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account qualitative information which cannot be measured in terms of
money. Industry cycles, strength of research and development are some
of the examples qualitative information that a business can collect using
special surveys.

6. Identify early signs of problems: If a product is not performing well

the management can identify it early on as the accounts are presented at
regular intervals. This will aid in overcoming the constraints early on and
avoiding future losses.

7. It helps in planning and preparing Budgets: various functional

budgets are prepared and accounting information are rearranged in
department wise, product wise, section wise and the like for proper
planning.

8. Improvement of Efficiency: The management accounting system

may eliminate various types of wastage, production, defectives and other
work thereby the workers efficiency may be improved.

9. Reliability: The tools used in management accounting system are

reliable. This procedure usually makes the data supplied to
management accurate and reliable.
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WHAT IS A MANAGEMENT ACCOUNTANT?

Management accountants provide a wide range of essential financial

analysis services to organisations. They prepare, develop and analyse
financial information so that leadership teams have reliable figures on
which to base their critical strategic decisions.
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FUNCTIONS (or ROLE) OF MANAGEMENT ACCOUNTANTS

The functions of management accountants are dictated by their job

positions, agreement with the organization, knowledge, and capabilities.
On this basis, the tasks of a management accountant are briefly explained
below:

1) Planning and Accounting

Management accountants prepare an accounting system covering costs,

sales forecasts, profit planning, production planning, and allocation of
resources. It should also include capital budgeting, short-term and long-

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term financial planning. They also prepare the procedures necessary to
implement the plan effectively.

2) Controlling

Management accountants assist in the control of an organization's

performance through the use of standard costing, accounting ratios,
budget control, revenue and funds flow statements, cost-cutting
initiatives, and assessing capital expenditure proposals and returns on
investment.

3) Reporting

Management accountants assist the top management in finding out the

root cause of an unfavorable operation or event by identifying the real
reasons for the adverse events and as well as the responsible parties and
comprehensively reporting them.

4) Coordinating

Management accountants improve an organization's efficiency and profits

by providing various coordination tools such as budgeting, financial
reporting, financial analysis and interpretation, and so on. These tools aid
management by comparing cost and financial records, preparing financial
budgets and establishing standard costs, and analyzing cost deviations to
enable management by exception.

5) Communication

Management accountants create a wide range of reports to communicate

results to superiors, inspire staff, retain effective control over their
operations, and help management to make smart decisions. Through
published financial statements and returns, they also inform the outside
world about their company's success.

6) Financial evaluation and Interpretation

Management accountants analyze the data and present it to the

management in a non-technical approach, together with their comments
and ideas, so that the shareholders and senior management employees
can understand it and make informed decisions.

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7) Tax Administration

Management accountants are in charge of tax policies and processes.

They make the reports that are required by various authorities available.
Further, they establish enough tax provisions, ensuring that quarterly tax
payments are made in advance, as required by the Income Tax Act, to
prevent the payment of penal interest on late tax payments.

8) Evaluation of External Effects

There may be changes in government policy and even existing laws.

These amendments and policy changes can affect business goals;
Management accountants assess the extent of any impact of these
external factors on the business and report it to the stakeholder to take
necessary precautionary measures

9) Economic appraisal

When the government makes regular announcements about the country's

economic situation, management accountants do an economic study and
determine the influence of current economic conditions on the company's
operations. They compile a report containing their observations and
present it to high management.

10) Asset Protection

Management accountants separate fixed asset registers for each type and
provide internal checks and controls to protect the company’s assets.
They also create the rules and regulations for each type of fixed asset and
get insurance coverage for all types of fixed assets.

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RELATIONSHIP BETWEEN MANAGEMENT ACCOUNTING AND FINANCIAL
ACCOUNTING

Financial accounting is concerned with the recording of day-to-

day transactions of the business. while management accounting
is concerned with using financial accounts for forecasting and
decision making.

How Is Management Accounting Different From Financial Accounting?

Financial accounting and management accounting have some inherent

differences. They are

Basis for Management Financial accounting

Comparison accounting

Purpose It is used for internal It is used for external

purpose reporting primarily,
although the
management also
reviews it

Regulation It is not regulated by any It has to be presented as

law per standards

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Users Its users are the Its users are
management of an shareholders, investors
organization and regulators

Objective It aids in internal decision preparing periodical

making reports

Mandatory Preparation and Preparation and

presentation of financial presentation is
statements is not mandatory.
mandatory

Audit It is not subject to audit Financial statements

must be audited

Frequency There is no defined Financial statements

frequency for preparation must be prepared for the
and presentation of the financial year and
statements presented

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Contents Management accounts Financial accounts
include both monetary include only monetary
and non-monetary information
information

Orientation future historical

Format of the
Financial
Statements not specified specified

Segment
reporting
Pertains to Pertains to the entire
individual organization. Certain
departments in figures may be broken
addition to the out for materially
entire organization. significant business
units.

Difference Between Cost Accounting and Management Accounting

BASIS OF MANAGEMENT
COST ACCOUNTING
COMPARISON ACCOUNTING

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Meaning The recording, The accounting in which the
classifying and both financial and non-
summarising of cost financial information are
data of an organisation provided to managers is
is known as cost known as Management
accounting. Accounting.

Information Type Quantitative. Quantitative and

Qualitative.

Objective Ascertainment of cost Providing information to

of production. managers to set goals and
forecast strategies.

Scope Concerned with Impart and effect aspect of

ascertainment, costs.
allocation, distribution
and accounting aspects
of cost.

Specific Yes No
Procedure

Recording Records past and It gives more stress on the

present data analysis of future
projections.

Planning Short range planning Short range and long range

planning

Interdependency Can be installed Cannot be installed without

without management cost accounting.
accounting.

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TECHNIQUES IN MANAGERIAL ACCOUNTING

In order to achieve business goals, managerial accounting uses a number
of different techniques.

 Marginal analysis: This assesses profits against various types of

costs. It primarily deals with the benefits of increased production. It
involves calculating the break-even point, which requires knowing
the contribution margin on the company’s sales mix. Here, sales mix
is the proportion of a product that a business has sold when
compared to the total sales of that business. This is used to
determine the unit volume for which the business’ gross sales are
equal to total expenditures. This value is used by managerial
accountants to determine the price points for various products.

 Constraint analysis: Managerial accounting monitors the

constraints on profits and cash flow with respect to a product. It
analyzes the principal bottlenecks and the problems they cause, and
calculates their impact on revenue, profit, and cash flow.

 Capital budgeting: This is an analysis of information in order to

make decisions related to capital expenditures. In this analysis, the
managerial accountants calculate the net present value and internal
rate of return to help managers with capital budgeting decisions like
calculating payback period or calculating accounting rate of return.

 Inventory valuation and product costing: This deals with

determining the actual cost of goods and services. The process
generally involves computing the overhead charges and assessment
of direct costs associated with cost of goods sold.

 Trend analysis and forecasting: This primarily deals with

variations in product costs. The resulting data is helpful in
identifying unusual patterns and finding efficient ways to identify
and resolve the underlying issues.

 Analysis of Financial Statements:

The analysis is an attempt to determine the significance and
meaning of the financial statement data so that a forecast may be
made of the prospects for future earnings, ability to pay interest and
debt maturities and profitability of a sound dividend policy.:

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 The techniques of such analysis are comparative financial
statements, trend analysis, cash funds flow statements and ratio
analysis. This analysis results in the presentation of information
which will help the business executives, investors and creditors.

 Standard Costing:
Standard costing is the establishment of standard costs under most
efficient operating conditions, comparison of actual with the
standard, calculation and analysis of variance, in order to know the
reasons and to pinpoint the responsibility and to take remedial
action so that adverse things may not happen again. This aspect is
necessary to have cost control.

 Budgetary Control:
The management accountant uses the tool of budgetary control for
planning and control of the various activities of the business.
Budgetary control is an important technique of directing business
operations in a desired direction, i.e., achieves a satisfactory return
on investment.

 Funds Flow Statement:

The management accountant uses the technique of funds flow
statement in order to analyse the changes in the financial position
of a business enterprise between two dates. It tells wherefrom the
funds are coming in the business and how these are being used in
the business. It helps a lot in financial analysis and control, future
guidance and comparative studies.

 Cash Flow Statement:

A funds flow statement based on increase or decrease in working
capital is very useful in long-range financial planning. It is quite
possible that there may be sufficient working capital as revealed by
the funds flow statement and still the company may be unable to
meet its current liabilities as and when they fall due. It may be due
to an accumulation of inventories and an increase in trade debtors.
In such a situation, a cash flow statement is more useful because it
gives detailed information of cash inflows and outflows. Cash flow
statement is an important tool of cash control because it
summarises sources of cash inflows and uses of cash outflows of a
firm during a particular period of time, say a month or a year. It is
very useful tool for liquidity analysis of the enterprise.

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LIMITATIONS OF MANAGERIAL ACCOUNTING

1. Dependency on Financial and Cost Records
Both financial and cost accounting information are used in the
management accounting system. The accuracy and validity of
management account is largely based on the accuracy if financial and
cost records maintained. These records determine the Strength and
weakness of management accounting.
2. Personal Bias
The analysis and interpretation of financial statements are fully depending
upon the capability of the analyst and interpreter. Hence, personal
prejudices and bias of an individual can affect the objectivity and
effectiveness of the conclusions and recommendations.
3. Lack of Knowledge and Understanding of the Related Subjects
Financial accounting, cost accounting, statistics, economics, psychology
and sociology are the related subjects of management accounting. The
organization can derive more benefits of management accounting if the
management accountant has thorough knowledge over related subjects. If
not so, the success of management accounting system is questionable.
4. Provides only Data
Under management accounting system, many alternatives are developed
to solve a problem and submitted before the management. Out of the
many alternatives available, the management can select any one of
alternatives or even discard all of them. Hence, management accounting
can only provide data and not prescribe any course of action.
5. Management Accounting is only a Tool
Management accounting is only a tool; it cannot replace management. Its
usefulness depends on the extent to which the available data are used by
management to make decisions.
6. Continuity and Participation
The decisions are taken by the management. Their implementation is
vested in the hands of management accountant. The continuous efforts of
management accountant and full participation of all levels of
management are necessary for successful operation of management
accounting system.
7. Costly Installation
The cost of installation of management accounting system is very high.
Hence, a small business organization can not bear the cost of such
installation. Moreover, the utility of this system is restricted only to big
and complex organizations.
8. Evolutionary State
Management accounting is a recent development discipline. The utility of
management accounting is depend upon the intelligent interpretation of

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the data available for managerial use. Hence, it is presumed that the
management accounting stands in evolutionary stage.
10. Limited Scope (serves only internal purpose)
Management accounting is limited to the internal needs of the
organization and does not consider external factors. External factors could
include the market situation, economic factors, and labor-related issues.
11. Lack of Standardization
Management accounting does not have the same standards as financial
accounting, which makes it difficult to compare performance from one
organization to another. This makes it difficult to measure a business’s
impact on the market as a whole.

12. Bias or internal resistance:

Traditional methods of accounting have been used for a long time.
This can lead to changes or new approaches meeting with
resistance from the majority.

Accounting staff will likely be hesitant to new working approaches.

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 UNIT - 5
BUDGETARY CONTROL
Dr. Mahasweta Bhattacharya

INTRODUCTION:

A budget is an accounting plan. It is a formal plan of action

expressed in monetary terms. It could be seen as a statement
of expected income and expenses under certain anticipated
operating conditions. It is a quantified plan for future activities
– quantitative blue print for action.

A budget is an estimation of revenue and expenses over a specified

future period of time and is usually compiled and re-evaluated on a
periodic basis.

Every organization achieves its purposes by coordinating

different activities. For the execution of goals efficient planning
of these activities is very important and that is why the
management has a crucial role to play in drawing out the plans
for its business. Various activities within a company should be
synchronized by the preparation of plans of actions for future
periods.

These comprehensive plans are usually referred to as budgets.

Budgeting is a management device used for short‐term
planning and control. It is not just accounting exercise.

MEANING AND DEFINITION:

BUDGET:

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 According to CIMA (Chartered Institute of Management
Accountants) UK, a budget is “A plan quantified in monetary
terms prepared and approved prior to a defined period of time,
usually showing planned income to be generated and,
expenditure to be incurred during the period and the capital to
be employed to attain a given objective.”

In a view of Keller & Ferrara, “a budget is a plan of action to

achieve stated objectives based on predetermined series of
related assumptions.”
G.A.Welsh states, “A budget is a written plan covering
projected activities of a firm for a definite time period.”

One can elicit the explicit characteristics of budget after

observing the above definitions. They are…
 It is mainly a forecasting and controlling device.

 It is prepared in advance before the actual operation of

the company or project.
 It is in connection with definite future period.
 Before implementation, it is to be approved by the
management.
 It also shows capital to be employed during the period.

BUDGETARY CONTROL:

BUDGETARY CONTROL - Meaning

Budgetary Control is a method of managing costs through preparation of
budgets. Budgeting is thus only a part of the budgetary control.
Budgetary Control is a method of managing costs through
preparation of budgets. Budgeting is thus only a part of the
budgetary control.

According to CIMA, “Budgetary control is the establishment of

budgets relating to the responsibilities of executives of a policy and
the continuous comparison of the actual with the budgeted results,
either to secure by individual action, the objective of the policy or to
provide a basis for its revision.”

The main features of budgetary control are:

1. Establishment of budgets for each purpose of the business.

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2. Revision of budget in view of changes in conditions.
3. Comparison of actual performances with the budget on a continuous
basis.
4. Taking suitable remedial action, wherever necessary.
5. Analysis of variations of actual performance from that of the
budgeted performance to know the reasons thereof.

OBJECTIVES OF BUDGETARY CONTROL:

Budgeting is a forward planning. It serves basically as a tool for

management control; it is rather a pivot of any effective scheme of
control.
The objectives of budgeting may be summarized as follows:

1. Planning: Planning has been defined as the design of a desired

future position for an entity and it rests on the belief that the
future position can be attained by uninterrupted management
action. Detailed plans relating to production, sales, raw‐material
requirements, labour needs, capital additions, etc. are drawn
out. By planning many problems estimated long before they
arise and solution can be thought of through careful study. In
short, budgeting forces the management to think ahead, to
foresee and prepare for the anticipated conditions. Planning is a
constant process since it requires constant revision with
changing conditions.
2. Co‐ordination: Budgeting plays a significant role in
establishing and maintaining coordination. Budgeting assists
managers in coordinating their efforts so that problems of the
business are solved in harmony with the objectives of its
divisions. Efficient planning and business contribute a lot in
achieving the targets. Lack of co‐ordination in an organization is
observed when a department head is permitted to enlarge the
department on the specific needs of that department only,
although such development may negatively affect other
departments and alter their performances. Thus, co‐ordination
is required at all vertical as well as horizontal levels.

3. Measurement of Success: Budgets present a useful means of

informing managers how well they are performing in meeting
targets they have previously helped to set. In many companies,
there is a practice of rewarding employees on the basis of their
accomplished low budget targets or promotion of a manager is
linked to his budget success record. Success is determined by
comparing the past performance with previous period's
performance.

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 4. Motivation: Budget is always considered a useful tool for
encouraging managers to complete things in line with the
business objectives. If individuals have intensely participated in
the preparation of budgets, it acts as a strong motivating force
to achieve the goals.

5. Communication: A budget serves as a means of communicating

information within

firm. The standard budget copies are distributed to all management

people provide not only sufficient understanding and knowledge of
the programmes and guidelines to be followed but also give
knowledge about the restrictions to be adhered to.

6. Control: Control is essential to make sure that plans and

objectives laid down in the budget are being achieved. Control,
when applied to budgeting, as a systematized effort is to keep
the management informed of whether planned performance is
being achieved or not.

ADVANTAGES OF BUDGETARY CONTROL:

In the light of above discussion one can see that, coordination and
control help the planning. These are the advantages of budgetary
control. But this tool offer many other advantages as follows:

1. This system provides basic policies for initiatives.

2. It enables the management to perform business in the most
professional manner because budgets are prepared to get the
optimum use of resources and the objectives framed.
3. It ensures team work and thus encourages the spirit of support and
mutual understanding among the staff.
4. It increases production efficiency, eliminates waste and controls the costs.
5. It shows to the management where action is needed to remedy a position.
6. Budgeting also aids in obtaining bank credit.
7. It reviews the present situation and pinpoints the changes which are
necessary.
8. With its help, tasks such as like planning, coordination and control
happen effectively and efficiently.
9. It involves an advance planning which is looked upon with support by
many credit agencies as a marker of sound management.

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 LIMITATIONS OF BUDGETARY CONTROL:

1. It tends to bring about rigidity in operation, which is harmful. As

budget estimates are quantitative expression of all relevant data,
there is a tendency to attach some sort of rigidity or finality to
them.
2. It being expensive is beyond the capacity of small undertakings.
The mechanism of budgeting system is a detailed process
involving too much time and costs.
3. Budgeting cannot take the position of management but it is only
an instrument of management. ‘The budget should be considered
not as a master, but as a servant.’ It is totally misconception to
think that the introduction of budgeting alone is enough to ensure
success and to security of future profits.
4. It sometimes leads to produce conflicts among the managers as
each of them tries to take credit to achieve the budget targets.
5. Simple preparation of budget will not ensure its proper
implementation. If it is not implemented properly, it may lower
morale.
6. The installation and function of a budgetary control system is a
costly affair as it requires employing the specialized staff and
involves other expenditure which small companies may find
difficult to incur.

ESSENTIALS OF EFFECTIVE BUDGETING:

1. Support of top management: If the budget structure is to be made

successful, the consideration by every member of the management
not only is fully supported but also the impulsion and direction should
also come from the top management. No control system can be
effective unless the organization is convinced that the management
considers the system to be important.
2. Team Work: This is an essential requirement, if the budgets are
ready from “the bottom up” in a grass root manner. The top
management must understand and give enthusiastic support to the
system. In fact, it requires education and participation at all levels.
The benefits of budgeting need to be sold to all.
3. Realistic Objectives: The budget figures should be realistic and
represent logically attainable goals. The responsible executives
should agree that the budget goals are reasonable and attainable.
4. Excellent Reporting System: Reports comparing budget and
actual results should be promptly prepared and special attention
focused on significant exceptions i.e. figures that are significantly
different from expected. An effective budgeting system also requires
the presence of a proper feed‐back system.

23
5. Structure of Budget team: This team receives the forecasts and
targets of each department as well as periodic reports and confirms
the final acceptable targets in form of Master Budget. The team also
approves the departmental budgets.
6. Well defined Business Policies: All budgets reveal that the
business policies formulated by the higher level management. In
other words, budgets should always be after taking into account the
policies set for particular department or function. But for this purpose,
policies should be precise and clearly defined as well as free from any
ambiguity.
7. Integration with Standard Costing System: Where standard
costing system is also used, it should be completely integrated with
the budget programme, in respect of both budget preparation and
variance analysis.
8. Inspirational Approach: All the employees or staff other than
executives should be strongly and properly inspired towards
budgeting system. Human beings by nature do not like any pressure
and they dislike or even rebel against anything forced upon them.

ESSENTIALS OF BUDGETARY CONTROL:

There are certain steps which are necessary for the successful
implementation budgetary control system. These are as follows:
1. Organisation for Budgetary Control
2. Budget Centres
3. Budget Mammal
4. Budget Officer
5. Budget Committee
6. Budget Period
7. Determination of Key Factor.
1. Organization for Budgetary Control:
The proper organization is essential for the successful preparation,
maintenance and administration of budgets. A Budgetary Committee is
formed, which comprises the departmental heads of various departments.
All the functional heads are entrusted with the responsibility of ensuring
proper implementation of their respective departmental budgets.
The Chief Executive is the overall in-charge of budgetary system. He
constitutes a budget committee for preparing realistic budgets A budget
officer is the convener of the budget committee who co-ordinates the
budgets of different departments. The managers of different departments
are made responsible for their departmental budgets.
2. Budget Centres:

24
A budget centre is that part of the organization for which the budget is
prepared. A budget centre may be a department, section of a department
or any other part of the department. The establishment of budget centres
is essential for covering all parts of the organization. The budget centres
are also necessary for cost control purposes. The appraisal performance of
different parts of the organization becomes easy when different centres
are established.
3. Budget Manual:
A budget manual is a document which spells out the duties and also the
responsibilities of various executives concerned with the budgets. It
specifies the relations amongst various functionaries.
4. Budget Officer:
The Chief Executive, who is at the top of the organization, appoints some
person as Budget Officer. The budget officer is empowered to scrutinize
the budgets prepared by different functional heads and to make changes
in them, if the situations so demand. The actual performance of different
departments is communicated to the Budget Officer. He determines the
deviations in the budgets and the actual performance and takes
necessary steps to rectify the deficiencies, if any.
He works as a coordinator among different departments and monitors the
relevant information. He also informs the top management about the
performance of different departments. The budget officer will be able to
carry out his work fully well only if he is conversant with the working of all
the departments.

5. Budget Committee:
In small-scale concerns the accountant is made responsible for
preparation and implementation of budgets. In large-scale concerns a
committee known as Budget Committee is formed. The heads of all the
important departments are made members of this committee. The
Committee is responsible for preparation and execution of budgets. The
members of this committee put up the case of their respective
departments and help the committee to take collective decisions if
necessary. The Budget Officer acts as convener of this committee.
6. Budget Period:
A budget period is the length of time for which a budget is prepared and
employed. The budget period depends upon a number of factors. It may
be different for different industries or even it may be different in the same
industry or business.
The budget period depends upon the following considerations:
(a) The type of budget i.e., sales budget, production budget, raw
materials purchase budget, capital expenditure budget. A capital
expenditure budget may be for a longer period i.e. 3 to 5 years purchase,
sale budgets may be for one year.

25
 (b) The nature of demand for the products.
(c) The timings for the availability of the finances.
(d) The economic situation of the country.
(e) The length of trade cycles.
All the above-mentioned factors are taken into account while fixing period
of budgets
7. Determination of Key Factor:
The budgets are prepared for all functional areas. These budgets are
interdependent and inter-related. A proper co-ordination among different
budgets is necessary for making the budgetary control a success. The
constraints on some budgets may have an effect on other budgets too. A
factor which influences all other budgets is known as Key Factor or
Principal Factor.
There may be a limitation on the quantity of goods a concern may sell. In
this case, sales will be a key factor and all other budgets will be prepared
by keeping in view the amount of goods the concern will be able to sell.
The raw material supply may be limited, so production, sales and cash
budgets will be decided according to raw materials budget. Similarly,
plant capacity may be a key factor if the supply of other factors is easily
available.
The key factor may not necessarily remain the same. The raw materials
supply may be limited at one time but it may be easily available at
another time. The sales may be increased by adding more sales staff, etc.
Similarly, other factors may also improve at different times.
The key factor also highlights the limitations of the enterprise. This will
enable the management to improve the working of those departments
where scope for improvement exists.
___________________________________________________________________________
____________________

CLASSIFICATION OF BUDGET:

The extent of budgeting activity varies from firm to firm. In a smaller

firm there may be a sales forecast, a production budget, or a cash
budget. Larger firms generally prepare a master budget. Budgets can
be classified into different ways from different points of view. The
following are the important basis for classification:

Functional Classification:

SALES BUDGET:

26
 The sales budget is an estimate of total sales which may be
articulated in financial or quantitative terms. It is normally
forms the fundamental basis on which all other budgets are
constructed. In practice, quantitative budget is prepared first
then it is translated into economic terms.
While preparing the Sales Budget, the Quantitative Budget is
generally the starting point in the operation of budgetary
control because sales become, more often than not, the
principal budget factor. The factor to be consider in forecasting
sales are as follows:

 Study of past sales to determine trends in the market.

 Estimates made by salesman various markets of company
products.
 Changes of business policy and method.
 Government policy, controls, rules and Guidelines etc.
 Potential market and availability of material and supply.

PRODUCTION BUDGET:
The production budget is prepared on the basis of estimated
production for budget period. Usually, the production budget is based
on the sales budget. At the time of preparing the budget, the
production manager will consider the physical facilities like plant,
power, factory space, materials and labour, available for the period.
Production budget envisages the production program for achieving
the sales target. The budget may be expressed in terms of quantities
or money or both. Production may be computed as follows: Units to
be produced = Desired closing stock of finished goods + Budgeted
sales – Beginning stock of finished goods.
PRODUCTION COST BUDGET:
This budget shows the estimated cost of production. The production
budget demonstrates the capacity of production. These capacities of
production are expressed in terms of cost in production cost budget.
The cost of production is shown in detail in respect of material cost,
labour cost and factory overhead. Thus production cost budget is
based upon Production Budget, Material Cost Budget, Labour Cost
Budget and Factory overhead.

RAW‐MATERIAL BUDGET:
Direct Materials budget is prepared with an intention to determine
standard material cost per unit and consequently it involves
quantities to be used and the rate per unit. This budget shows the
estimated quantity of all the raw materials and components needed

27
for production demanded by the production budget. Raw material
serves the following purposes:
 It supports the purchasing departmentin
scheduling the purchases.
 Requirement of raw‐materials is decided
on the basis of production budget.
 It provides data for raw material control.

Helps in deciding terms and conditions of purchase like


credit purchase, cash purchase, payment period etc.
It should be noted that raw material budget generally deals with only
the direct materials whereas indirect materials and supplies are
included in the overhead cost budget.

PURCHASE BUDGET:
Strategic planning of purchases offers one of the most important
areas of reduction cost in many concerns. This will consist of direct
and indirect material and services. The purchasing budget may be
expressed in terms of quantity or money.
The main purposes of this budget are:
 It designates cash requirement in respect of purchase to
be made during budget period; and
 It is facilitates the purchasing department to plan its
operations in time in respect of purchases so that long
term forward contract may be organized.

LABOUR BUDGET:
Human resources are highly expensive item in the operation of an
enterprise. Hence, like other factors of production, the management
should find out in advance personnel requirements for various jobs in
the enterprise. This budget may be classified into labour requirement
budget and labour recruitment budget.
The labour necessities in the various job categories such as unskilled,
semi‐skilled and supervisory are determined with the help of all the
head of the departments. The labour employment is made keeping in
view the requirement of the job and its qualifications, the degree of
skill and experience required and the rate of pay.
PRODUCTION OVERHEAD BUDGET:
The manufacturing overhead budget includes direct material, direct
labour and indirect expenses. The production overhead budget
represents the estimate of all the production overhead i.e. fixed,
variable, semi‐variable to be incurred during the budget period.
The reality that overheads include many different types of expenses
creates considerable problems in:

28
1. Fixed overheads i.e., that which is to remain stable irrespective of
vary in the volume of output,
2. Apportion of manufacturing overheads to products manufactured,
semi variable cost i.e., those which are partly variable and partly
fixed.
3. Control of production overheads.
4. Variable overheads i.e., that which is likely to vary with the output.

The production overhead budget engages the preparation of

overheads budget for each division of the factory as it is desirable to
have estimates of manufacturing overheads prepared by those
overheads to have the responsibility for incurring them. Service
departments cost are projected and allocated to the production
departments in the proportion of the services received by each
department.

SELLING AND DISTRIBUTION COST BUDGET:

The Selling and Distribution Cost budget is estimating of the cost of
selling, advertising, delivery of goods to customers etc. throughout
the budget period. This budget is closely associated to sales budget
in the logic that sales forecasts significantly influence the forecasts of
these expenses. Nevertheless, all other linked information should also
be taken into consideration in the preparation of selling and
distribution budget.
The sales manager is responsible for selling and distribution cost
budget. Naturally, he prepares this budget with the help of managers
of sub‐divisions of the sales department. The preparation of this
budget would be based on the analysis of the market condition by the
management, advertising policies, research programs and many
other factors. Some companies prepare a separate advertising
budget, particularly when spending on advertisements are quite high.

ADMINISTRATION COST BUDGET:

This budget includes the administrative costs for non‐manufacturing
business activities like director’s fees, managing directors’ salaries,
office lightings, heating and air condition etc. Most of these expenses
are fixed so they should not be too difficult to forecast. There are
semi‐variable expenses which get affected by the expected rise or fall
in cost which should be taken into account. Generally, this budget is
prepared in the form of fixed budget.

CAPITAL‐ EXPENDITURE BUDGET:

29
This budget stands for the expenditure on all fixed assets for the
duration of the budget period. This budget is normally prepared for a
longer period than the other functional budgets. It includes such
items as new buildings, land, machinery and intangible items like
patents, etc.
This budget is designed under the observation of the accountant
which is supported by the plant engineer and other functional
managers. At the time of preparation of the budget some important
information should be observed:
 Overfilling on the production facilities of certain
departments as revealed by the plant utilization budget.
 Long‐term business policy with regard to technical
developments.
 Potential demand for certain products.

CASH BUDGET:
The cash budget is a sketch of the business estimated cash inflows
and outflows over a specific period of time. Cash budget is one of the
most important and one of the last to be prepared. It is a detailed
projection of cash receipts from all sources and cash payments for all
purposes and the resultants cash balance during the budget. It is a
mechanism for controlling and coordinating the fiscal side of business
to ensure solvency and provides the basis for forecasting and
financing required to cover up any deficiency in cash. Cash budget
thus plays a vital role in the financing management of a business
undertaken.

Cash budget assists the management in determining the future

liquidity requirements of the firm, forecasting for business of those
needs, exercising control over cash. So, cash budget thus plays a
vital role in the financial management of a business enterprise.

Function of Cash Budget:

 It makes sure that enough cash is available when it is
required.
 It designates cash excesses and shortages so that steps
may be taken in time to invest any excess cash or to
borrow funds to meet any shortages.
 It shows whether capital expenditure could be financed
internally.
 It provides funds for standard growth.
 It provides a sound basis to manage cash position.

Advantages of Cash Budget:

30
 1. Usage of Cash: Management can plan out the use of cash in
accord with the changes of receipt and payment. Payments can
be planned when sufficient cash is available and continue the
business activity with the minimum amount of working capital.
2. Allocation for Capital Investment: It is dual benefits such as
capital expenditure projects can be financed internally and can
get an idea for cash availability of capital investment.
3. Provision of Excess Funds: It reveals the availability of
excess cash. In this regard management can decide to invest
excess funds for short term or long term according to the
requirements in the business.
4. Pay‐out Policy: This budgetary system may help the
management for future pay‐out policy in the form of dividend. In
case the cash budget liquid position is not favourable, the
management may reduce the rate of dividend or maintain
dividend amount or skip dividend for the year.
5. Provision for acquiring Funds: It gives the top level
management ideas for acquiring funds for particular time
duration and sources to be explored.
6. Profitable Use of Cash: Business person can take decision for
the best use of liquidity to make more profitable transaction. It
can be used at the time of bulk purchase payments and one get
the benefit of discount.

Limitation of Cash Budget:

1. Complex Assumption: Business is full of uncertainties,
so it is very difficult to have near perfect estimates of
cash receipts and payments, especially for a longer
duration. It can be predicted for short duration such as of
three to four months.
2. Inflexibility: If the finance manager fails to show
flexibility in implementing the cash budget, it will incur
adverse effects. If the manager follows strictly adheres to
the estimates of cash inflow it may negatively result in
losing customers. Likewise, loyalty in payments may lead
to deterioration of liquid position.
3. Costly: Application of this technique necessitates
collecting of statistical information from various sources
and expert personnel in operation research would be the
costliest deal. It becomes expensive which may not be
affordable to small business houses. In addition, finding
out experts is not always possible. In this situation the
long term predictions do not prove correct.

Methods:
1. Receipt and payment: It is most popular and is universally
used for preparing cash budget. The assumption of statistical

31
 data is arrived at calculated on the basis of requirements like
monthly, weekly or fortnightly. On account of elasticity, this
method is used in forecasting cash at different time periods
and thus it helps in controlling cash distributions.

a. Cash receipts from customers are based on sales forecast.

The term of sale, lag in payment etc., are generally taken
into consideration.
b. Cash receipts from other sources, such as dividends and
interest on trade investment, rent received, issue of
capital, sale of investment and fixed assets.
c. Cash requirements for purchase of materials, labour and
salary cost and overhead expenses based on purchasing,
personnel and overhead budgets.
d. Cash requirements for capital expenditure as per the capital
expenditure budget.
e. Cash requirements for other purposes such as payment of
dividends, income‐tax liability, fines and penalties.
i. Estimating Cash Receipts: Generally main sources of cash
receipts are sales, interest and dividend, sales of assets and
investments, capital borrowings etc. The Company estimates
time‐lag on the basis of past experience of cash receipts on
credit sales while cash sales can be easily determined.
ii. Estimating Cash Payments: It can be decided on the basis of
various operating budgets prepared for the payment of credit
purchase, payment of labour cost, interest and dividend,
overhead charges, capital investment etc.

2. Adjusted Profit and Loss Account: This method is based on

cash and non‐cash transactions. This method estimates closing
cash balance by converting profit into cash. The hypothesis of
this method is that the earning of profit brings equal amount of
cash into the business.

The net profit shown by profit and loss account does not signify
the actual cash flow into the business. This also leads to
another assumption, that is the business will remain static, i.e.
there will be no wearing out or increase of assets and changes
of working capital so that the total cash on hand for the
business would be equal to the profit earned.

3. Budgeted Balance Sheet Method: This method looks like

the Adjusted Profit and Loss Account method only, except that
in this method a Balance Sheet is projected and in that method
Profit and Loss Account is adjusted. In this method Balance
Sheet is prepared with the projected amount of all assets and

32
 liabilities except cash at the end of budget period. The cash
balance will find out balancing amount. If assets side is higher
than liability side it would be the bank overdraft while liability
side is higher than assets side it gives bank balance. This
method is used by the stable business houses.

4. Working Capital Differential Method: It is based on the

estimate of working capital. It begins with the opening working
capital and is added to or deducted from any changes made in
the current assets except cash and current liabilities. At the
end of the budget period balance shows the real cash balance.
This method is quite similar to the Balance Sheet method.

MODEL OF CASH BUDGET

Particular Januar Februar Marc

s y y h
Opening Balance ‐ ‐ ‐
Add: Receipts:
Cash Sales ‐ ‐ ‐
Receipts from Debtors ‐ ‐ ‐
Interest and Dividend ‐ ‐ ‐
Sale of fixed assets ‐ ‐ ‐
Sale of Investments ‐ ‐ ‐
Bank Loan ‐ ‐ ‐
Issue Shares & Debenture ‐ ‐ ‐
Others ‐ ‐ ‐
Total Receipts (A) ‐ ‐ ‐
Less: Payments
Cash Purchases ‐ ‐ ‐
Payment to creditors ‐ ‐ ‐
Salaries & wages ‐ ‐ ‐
Administrative expenses ‐ ‐ ‐
Selling expenses ‐ ‐ ‐
Dividend payable ‐ ‐ ‐
Purchase of Fixed Assets ‐ ‐ ‐
Repayment of Loan ‐ ‐ ‐
Payment of taxes ‐ ‐ ‐
Total Payments (B) ‐ ‐ ‐
Closing Balance (A ‐ B) ‐ ‐ ‐

FIXED AND FLEXIBLE BUDGET:

33
1. FIXED BUDGET:
A fixed budget is prepared for one level of output and one set of
condition. This is a budget in which targets are tightly fixed. It is
known as a static budget. It is firm and prepared with the
assumption that there will be no change in the budgeted level
of motion. Thus, it does not provide room for any modification
in expenditure due to the change in the projected conditions
and activity. Fixed budgets are prepared well in advance.

This budget is not useful because:

 The conditions go on the changing and cannot be expected to be

firm.
 The management will not be in a position to assess, the
performance of different heads on the basis of budgets
prepared by them because to the budgeted level of activity.
 It is hardly of any use as a mechanism of budgetary control
because it does not make any difference between fixed,
semi‐variable and variable costs
 It does not provide any space for alteration in the budgeted
figures as a result of change in cost due to change in the
level of activity.

2. FLEXIBLE BUDGET:
This is a dynamic budget. In comparison with a fixed budget, a
flexible budget is one “which is designed to change in relation to
the level of activity attained.” An equally accurate use of the
flexible budgets is for the purposes of control.

Flexible budgeting has been developed with the objective of

changing the budget figures so that they may correspond with the
actual output achieved. It is more sensible and practical, because
changes expected at different levels of activity are given due
consideration. Thus a budget might be prepared for various levels
of activity in accord with capacity utilization.

Flexible budget may prove more useful in the following conditions:

 Where the level of activity varies from period to period.

 Where the business is new and as such it is difficult to forecast
the demand.
 Where the organization is suffering from the shortage of any
factor of production. For example, material, labour, etc. as

34
 the level of activity depends upon the availability of such a
factor.
 Where the nature of business is such that sales go on changing.
 Where the changes in fashion or trend affects the production and
sales.
 Where the organization introduces the new products or
changes the patterns and designs of its products frequently.
 Where a large part of output is intended for the export.

Uses of Flexible Budget:

In flexible budgets numbers are adjustable to any given set of
operating conditions. It is, therefore, more sensible than a fixed
budget which is true only in one set of operating environment.

Flexible budgets are also useful from the view point of control. Actual
performance of an executive should be compared with what he
should have achieved in the actual circumstances and not with what
he should have achieved under quite different circumstances. At
last, flexible budgets are more realistic, practical and useful. Fixed
budgets, on the other hand, have a limited application and are suited
only for items like fixed costs.

Preparation of a Flexible Budget

The preparation of a flexible budget requires the analysis of total
costs into fixed and variable components. This analysis of course is,
not unusual to the flexible budgeting, is more important in flexible
budgeting then in fixed budgeting. This is so because in flexible
budgeting, varying levels of output are considered and each class of
overhead will be different for each level.
Thus the flexible budget has the following main distinguishing
features:
 It is prepared for a range of activity instead of a single level.
 It provides a dynamic basis for comparison because it
is automatically related to changes in volume.

The formulation of a flexible budget begins with analyzing the

overhead into fixed and variable cost and determining the extent to
which the variable cost will vary within the normal range of activity.

There are two methods of preparing such a budget:

i. Formula Method / Ratio Method: This is also known as the
Budget Cost Allowance Method. In this method the budget
should be prepared as follows:
a. Before the period begins:

35
  Budget for a normal level of activity,
 Segregate into fixed and variable costs,
 Compute the variable cost per unit of activity

b. At the end of the period:

 Ascertain the actual activity
 Compute the variable cost allowed for this level, add the fixed cost to
give the budget cost allowance.
The whole process is expressed in the formula:
Allowed cost = Fixed cost + (Actual units of activity for the period)
(Variable cost per unit of activity)
ii. Multi‐Activity Method: This method involves computing a budget for
every major level of activity. When the actual level of activity is known,
the allowed cost is found “interpolating” between the budgets of
activity levels on either side.

 Different levels of activity are expressed in terms of either

production units or sales values. The levels of activity are generally
expressed in production units or in terms of sales values.
 The fixation of the budget cost gives allowance for the budget
centres. According to CIMA London, the budget cost allowance
means, "the cost which a budget centre is expected to incur during a
given period of time in relation to the level of activity attained by the
budget centre."
 The determination of the different levels of activity for which the
flexible budget is to be prepared.

(3) Graphic Method: In this method, estimates of budget are

presented graphically. In this costs are divided into three classes,
viz., fixed, variable and semi‐variable cost. Values of costs are
obtained for different levels of production. These values are signified
in the form of a graph.

Model of Flexible Budget

Capacity Utilization
Particular 60 80 100
s % % %
1. Prime Cost:
‐ Direct Material ‐ ‐ ‐
‐ Direct Labour ‐ ‐ ‐
‐ Direct expenses (if any) ‐ ‐ ‐
Total (A) ‐ ‐ ‐
2. Variable overheads:

36
 ‐ Maintenance & repairs ‐ ‐ ‐
‐ Indirect Labour ‐ ‐ ‐
‐ Indirect Material ‐ ‐ ‐
‐ Factory overheads ‐ ‐ ‐
‐ Administrative Overheads ‐ ‐ ‐
‐ Selling & distribution O/H ‐ ‐ ‐
Total (B) ‐ ‐ ‐
3. Marginal Cost (A + B) ‐ ‐ ‐
4. Sales ‐ ‐ ‐
5. Contribution ( Sales ‐ MC) ‐ ‐ ‐
6. Fixed cost
‐ Factory overheads ‐ ‐ ‐
‐ Administrative ‐ ‐ ‐
Overheads
‐ Selling & distribution O/H ‐ ‐ ‐
Total (C) ‐ ‐ ‐
7. Profit or Loss (C‐ FC) ‐ ‐ ‐

ZERO BASE BUDGETING [ZBB]:

The ‘Zero‐Base’ refers to a ‘nil‐budget’ as the starting point. It

starts with a presumption that the budget for the next period is
‘zero’ until the demand for a function, process, or project is not
justified for single penny. The assumption is that without such
justification, no expenditure will be allowed. In effect, each
manager or functional head is required to carry out cost‐benefit
analysis of each of the activities, etc. under his control and for
which he is responsible.

The method of ZBB suggests that the business should not

only make decision about the proposed new programmes but it
should also, regularly, review the suitability of the existing
programmes. This approach of preparing a budget is called
incremental budgeting since the budget process is concerned
mainly with the increases or changes in operations that are likely
to occur during the budget period.

This method for the first time was used by the Department
of Agriculture, U.S.A. in the 19 century. Other State Governments
th

of the U.S.A. found this method helpful and so almost all the states
took deep interest in the ZBB method. A number of states of
America use this technique even today. The ICAI has brought out a
research in the form of a monograph showing the application of
the ZBB method that worries in tandem with the concerns for

37
 national environment and its requirements. In India, however, the
ZBB approach has not been fully accepted and actualized.

"ZBB is a management tool, which provides a systematic

method for evaluating all operations and programmes, current or
new, allows for budget reductions and expansions in a rational
manner and allows re‐allocation of sources from low to high
priority programmes."

‐ David Lieninger

ZBB is a planning, resource allocation and control tool. It, however,

presupposes that
a. There is an efficient budgeting system within the enterprise.
b. Managers can develop quantitative measures for use in
performance evaluation.
c. Among the new suggestions and programmes, along with
old ones are put to a strict scrutiny.
d. Funds are diverted from low‐priority suggestions to high priority
suggestions.

PROCEDURE OF ZERO‐BASE BUDGETING:

1. Determination of the objective: This is an initial step for

determining the objective to introduce ZBB. It may result into the
decreased cost in personnel overheads or debunk the projects
which do not fit in the business structure or which are not likely to
help accomplish the business objectives.
2. Degree at the ZBB is to be introduced: It is not possible
every time to evaluate every activity of the whole business. After
studying the business structure, the management can decide
whether ZBB is to be introduced in all areas of business activities
or only in a few selected areas on the trial basis.
3. Growth of Decision units: Decision units submit their data as to
which cost benefit analysis should be done in order to arrive at a
decision that helps them decide to continue or abandon. It could
be a functional department, a programme, a product‐line or a
sub‐line. Here the decision unit sexist independent of all the other
units so that when the cost analysis turns unfavourable that
particular unit could be closed down.
4. Growth of Decision packages: Decision units are to be identified
for preparing data relating to the proposals to be included in the
budget, concerned manager analyzes the activities of his or her
own decision units. His job is to consider possible different ways
to fulfill objectives. The size of the business unit and the volume
of goods it deals with determine the number of decision units and
packages. The decision package has to contain all the information

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 which helps the management in deciding whether the information
is necessary for the business, what would be the estimated costs
and benefits expected from it.
5. Assessment and Grading of decision packages: These
packages invented and formulated are submitted to the next level
of responsibility within the organization for ranking purposes.
Ranking basically decides as to whether or not to include the
proposals in the budget. The management ranks the different
decision packages in the order from decreasing benefit or
importance to the organization. Preliminary ranking is done by the
unit manager himself and for the further review it is sent to the
superior officers who consider overall objectives of the
organization.
6. Allotment of money through Budgets: It is the last step
engaged in the ZBB process. According to the cost benefit
analysis and availability of the funds management has ranks and
thereby a cut‐off point is established. Keeping in view reasonable
standards, the approved designed packages are accepted and
others are rejected. The funds are then allotted to different
decision units and budgets relating to each unit are prepared.

Advantages:
 ZBB rejects the attitude of accepting the current position
in support of an attitude of inquiring and testing each item
of budget.
 It helps improve financial planning and management
information system through various techniques.
 It is an educational process and can promote a management
team of talented and skillful people who tend to promptly
respond to changes in the business environment.
 It facilities recognition of inefficient and unnecessary activities
and avoid wasteful expenditure.
 Cost behavior patterns are more closely examined.
 Management has better elasticity in reallocating funds for
optimum utilization of the funds.

Disadvantages:
 It is an expensive method as ZBB incurs a huge cost every in its
preparation.
 It also requires high volume of paper work; hence sometimes it
becomes a tedious job.
 In ZBB there is a danger of emphasizing short‐term benefits at
the expenses of long term ones.
 This is not a new method for evaluating various alternatives, and cost‐
benefit analysis.

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 The psychological effects can also not be ignored. It holds out
high hopes as a modern technique, claiming to raise the
profitability and efficiency of the business.

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