BUDGETING AND BUDGETARY CONTROL
?BUDGETING AND BUDGETARY CONTROL
?I like?to examine the concept of budgeting and budgetary control by dwelling on the following areas.
Definitions: The concept of Budget
?Budget is defined as formal written statement of management’s plans for the future expressed in financial terms. The plans (objectives) must be sound and attainable.It must be essentially SMART.SMART here means specific, measurable ,attainable, realistic and time bound. ?It is like an architect’s blue-print to a builder or the navigator’s flight plan to a pilot.
Budgeting and Standard Costs
(a)???????????????Accounting and financial tools aimed at assisting management in planning and control operations. Cost accounting which is aimed at planning production and controlling costs.
(b)??????????????Essentials of budgeting
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·???????Establishment of specific goals for future operations.
·???????Periodic comparison of actual results vs. set goals
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Budgeting and Budgets
(c)remove hunches and intuition in managing business concerns,if the planning is based on careful study, investigation and research.
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(d)???????Budget Performance Reports: Control feature use for periodic Comparison to evaluate planned objectives with actual performance
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(e)???????The Accountants Role in Budgeting Assist Management in:
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???????????*Investigation phase of budget preparation
???????????*Translating management’s plans into financial terms
???????????*Preparing budget performance reports and related analysis
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Most of the above problems can be mitigated or eliminated if all concerned with budgeting are trained to perceive the human implications of the budget system.
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Management Basic Functions
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Planning
Organizing
Co-ordination
Control
For the purpose of this article I ?shall concentrate on planning and control.
(a)??Planning: Process of selecting realistically attainable business objectives and formulating the general policies and specific directions essential to achieve such objectives.
Planning Process
The decision-making process of management starts with planning. Planning is the design of a desired future state of an entity and of the effective ways of bringing it about. In other words, planning involves the determination of the future course of action for accomplishing the objectives of the enterprise. The basic purpose of planning is to provide guidelines for making decisions. It is a feed forward process to reduce uncertainty about the future. The planning process is based on the conviction that management can plan its activities and condition the state of the enterprise that determine its destiny.
?The task of planning the enterprise activities involves the identification of relevant variables – controllable and non-controllable. The controllable variables are influenced by management and can be controlled and manipulated to the best advantage of the enterprise. The non-controllable variables can, however, be anticipated to minimize their unfavourable effects. For effective management, the evaluation of and planning for both the controllable and non-controllable variables is necessary. In many situations, the non-controllable variables significantly influence the controllable variables; ignoring them can, thus render planning meaningless. The examples of controllable variables are employee sales methods and research and development.
?In contrast, the examples of non-controllable variables are population changes, gross national product, competitive activities of the firm, customers’ attitude, state of economic condition and government action.
?Planning is a continuous process. Business conditions do not remain static, they change rapidly and therefore, plans should be revised and reformulated to adapt to the changing conditions. This planning process may be formal or informal. The formal plans are properly structured and are expressed in written forms. Formal planning is certainly better than informal planning; “no planning” is of course, worse than informal planning. It should be realized that too much over-formalization is also dangerous. A reasonable balance should be struck between the formal and informal planning.
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The planning process of an enterprise would generally involve four fundamental steps:
?Establishing the objectives
·???Determining the short-range objectives or goals
??Developing strategies, and
·???????Formulating profit plans or budgets.
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???Objectives
Goals
·???????The term goals refer to ends sought by organizations.
·???????Generally, there are different interpretations of goals
·???????One method of defining goal is to consider the concept as short – term objectives.
·???????The other view considers goal as long as term objectives.
·???????The most important characteristics of goal is the fact that the concept provides
direction to organization.
·???????Goals are usually expressed in terms of purpose, mission and objectives.
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Strategies
Strategies lay down the foundation for attaining the objectives and goals of the enterprise.
Strategies specify the ways to achieve the goals operationally. For example, the strategies of firm may include use of retained earnings for expansion, keeping debt at a reasonable level, expanding sales through price reduction and aggressive advertisement.
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Profit Plan or Budget
It may thus be concluded that the planning process involves determining the objectives and goals for an enterprise, developing strategies to attain objectives and goals so determined and establishing responsibility of units and individuals to carry out strategies. The final step of the planning process is the preparation of plans or budgets.
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The formalization of the objectives, goals and strategies for operational purposes is called the profit planning or budgeting. A profit plan or budget is the formal expression of the enterprises plans and objectives, stated in financial terms, for a specified future period of time. It is called the profit plan (or the budget) because it explicitly states the goals in terms of time, expectations and expected financial results for each major segment of the entity. The budget permits every level of activities and unifies the diverse activities of the enterprise.
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Top Management Support
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A budgeting system will be an utter failure if it is not initiated and supported by top management. Top management must realize that budgeting is not merely an accounting device, but it is an important management tool. Top management must: (i) understand the nature and characteristics of budgeting; (ii) be convinced that this particular approach to managing is preferable for their situation; (iii) be willing to devote the effort required to make it operative; (iv) support the programme in all its ramifications; (v) view the results of the planning process as performance commitments. A company will be able to implement the budget plans proficiently and effectively if top management has a positive attitude towards budgeting and gives directions for budget implementations.
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It is therefore, one of the most difficult problems of the financial manger or the budget director to “sell” the idea of budgeting to the managing director and other top officials.
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The support of top management for the budgeting system implies that it is confident about its capability to plan the future course of action and run the enterprise successfully. Top management’s confidence in the budgeting process makes the subordinates more confident and conscious. It has been shown by the behaviourial researches that subordinates of a manager, who has become cost conscious through his confidence in budgeting, will be approximately three times more cost-conscious than the subordinates of a manager who is not cost-conscious.
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Top management should not only have a positive attitude towards budgeting but should also devote necessary time and resources to the preparation and implementation of budgets. Budget estimates are generally prepared by the line managers, but top management has the responsibility of coordinating budgets of different departments and approving them finally.
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It will also resolve conflicts of various departments regarding resource allocation. Top management should also initiate a follow-up procedure to see that there is effective implementation of budgets.
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Clear and Realistic Goals
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Budgeting is a means to achieve goals and objectives. All planning pre-supposes that objectives and goals have been clearly and unambiguously established. Budgeting will not succeed if the goals to be achieved are not clear; budget implementation will not be systematic. In the absence of goal clarity, employees will lack a proper direction, the efforts of management will be wasted thus. The financial manager or the budget director, therefore, must ensure that objectives and goals have been properly laid down. As far as possible objectives and goals must be written in clear terms. But too much formality should be avoided as it can make budgeting system inflexible.
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The enterprise objectives and budget goals to be accomplished through budgeting should be reasonable and realistic; they should be capable of attainment. Budget goals should not be set at too high or too low a level. Goals set at a very high level are impossible to attain and as a result, have a depressing effect on the employees morale. Once the employees know that they are unrealistic and unattainable, they do not provide any challenge to employees. Their achievement does not require any special effort and therefore employees do not feel motivated. The enterprise objectives and budget goals must provide a real challenge and should be capable of motivating employees. What are the realistic objectives and goals for an enterprise depend upon a host of factors, such as size of the enterprise.
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Managerial philosophy and quality, age of the enterprise, nature of activities and many psychological and other factors. Goals set realistically provide better motivation to employees in the long run.
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Assignment of Authority and Responsibility
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A sound organizational structure is essential for the success of the budgetary system. Authorities and responsibilities of each structure and a clear-cut assignment of authorities and responsibilities provide an effective means to achieve the enterprise objectives and budget goals in a coordinated and efficient manner. The budgetary system should be established in terms of the assigned activities and responsibilities, the performance of each manager should be evaluated in terms of the assigned authorities and responsibilities. If there is no synchronization between the budgeting system and the organization structure of the enterprise the planning and control system would not be effective. In the absence of the clear-cut assignment of authorities and responsibilities either managers cannot be held accountable for those activities for which they have no responsibility.
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The type of organizational structure for an enterprise will depend upon the leadership style of top management. An enterprise may have a formally defined organizational structure or an informal organizational structure. Usually, firms have a combination of both formal and informal organizational structure. Whatever the organizational structure, the budgetary system should be turned in accordance with such structure.
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Creation of Responsibility Centres
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A small firm can possibly be managed by an individual or a small group of individuals. But the activities of a large firm cannot be supervised by an individual or a few individuals. For effective control of activities, a large firm is divided into meaningful segments, departments or divisions. Each sub-unit has certain activities to perform and its manager is assigned specific authority and responsibility to carry out those activities and is held responsible for his decision affecting those activities. The sub-units of an enterprise for the purpose of control are called responsibility centres or decision centres. A responsibility centre is a sub-unit of an organization under the control of a manager who has the responsibility for the activities of that responsibility centre. The responsibility centre can be a big unit, such as a production department or a small unit, such as a cash section of an accounting department or a machine in the production department. The important criteria for creating a responsibility centre are that the unit of the organization should be separable and identifiable for operating purposes and that the performance measurement should be possible.
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For planning and control purposes, responsibility centres are usually classified into three classes: cost centres, profit centres and investment centres.
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Cost Centre: A cost centre is a responsibility centre where the manager is responsible only for costs (expenses) incurred in the sub-unit. He is not responsible for profit or investment in the centre. The performance of the managers is evaluated by comparing the actual expenses incurred with the budgeted expenses for the cost centre. For control purposes, the management attention is focused upon the variance between actual and budgeted expenses.
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In a cost centre the consequences of decisions are measured in financial terms. Thus, the effectiveness and efficiency of the cost centre cannot be properly evaluated. A cost centre spending the least is considered as the best. This kind of analysis, of course, ignores the contributions made by the cost centre to the firm’s overall profitability.
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Profit Centre: A profit centre is also known as a contribution margin centre, is a responsibility centre where the manager is responsible for both costs and revenues and thus, for profit (or contribution margin). A profit centre is more relevant for profit planning and control as it allows the measurement of both output and input units of the centre.
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To ensure effective control through the profit centre control system, the (controllable and non-controllable) activities should be identified. The manager of a profit centre should be held responsible only for those costs and revenues which are controllable by him through his decisions. The indirect costs are usually non-controllable, therefore, they may not be allocated to a profit centre. If the allocation of indirect costs is avoided, one may think in terms of contribution margin centres, rather than profit centres. Contribution margin is the difference between controllable (variable) costs and revenues of the centre.
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Investment Centre: An investment centre is a responsibility centre where the manager is responsible for costs and revenues as well as the investment in assets used by the centre. In an investment centre, performance is assessed not only by profit, but by relating profit to the investment. Thus, return on investments is used as the performance evaluation criterion in an investment centre. In a sense, investment centres are treated as separate firms where the manager is responsible for the overall activities affecting costs, revenues and investment.
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The creation of responsibility centres – costs centres and investment centres is essential for successfully implementing plans (budgets), attaining objectives an accomplishing control. A budgetary system should be tailored to the organizational sub-units - the responsibility centres.
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Adaptation of the Accounting System
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The accounting system catering only to the needs of external users is not adequate for the purpose of profit planning and control and internal management. Budgeting is based on the data generated by the accounting system. Control of performance involves the comparison of actual performance (results) with the planned performance. Therefore the accounting system should be suitably adapted to facilitate planning and control process; it should be structured around the area of responsibility. In fact, a sound budgetary system needs the creation of a responsibility accounting system. A responsibility accounting system is primarily oriented towards the organizational responsibility centres. An accounting system, tailored to the responsibility structure of the enterprise generates data that are relevant to the planning and control system.
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A cost accounting system has two primary aims: (i) to measure the cost of production and (ii) to furnish data for planning and control. Historical cost accounting has paid more attention to the measurement of cost of production than the planning and control functions. In responsibility accounting, the emphasis is on planning and control; accounts are classified on responsibility basis, not on a product cost basis. The cost accumulated for planning and control purposes can easily be recast for product costing purposes. But it is difficult to use cost data accumulated for product costing purposes for planning and control. In summary, it may be stated that, for effective and successful budgeting the accounting system must be structured around the planning and control needs.
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Full Participation
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Full participation of managers and their subordinates at all levels should be sought in developing the budgetary system. The participation should be meaningful and real. If employees have effectively participated in developing the budget goals and targets, they will make special efforts to see that the budgeting process succeeds. A meaningful participation creates a positive motivation. Participation tends to increase commitment. Commitment tends to heighten motivation, motivation which is job-oriented tends to make managers work harder and move productively; and harder and more productive work by managers tends to enhance the Company’s prosperity; therefore participation is good. To reemphasize, it is the real and meaningful participation that is good. A non-serious effort on the part of top management to seek the participation of managers and their subordinates will not motivate them, rather, at times it produces negative motivation and make employees less productive.
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To seek meaningful participation of all persons in the enterprise is a difficult task. Some persons do not at all react to any scheme of participations while others react very favourably. All individuals should be motivated to participate in the budgeting process. Although participation of all should be sought in the budget preparation and implementation, the suggestions made by various persons should be carefully evaluated and analysed before they are accepted, should be understood well that the responsibility to prepare budgets lies on the line managers.
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The financial manager or the budget director is a staff manager, and his role is to coordinate and supervise the preparation of budgets. The budgets developed by the line executives will be their own budgets; they will have no reasons to say that the budgets cannot be carried out. Thus, it is essential that line executives who must achieve the plans and goals must be deeply involved in providing the planning and decisional imports for their respective departments. This procedure makes possible effective implementation of the participation principle in management.
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Budget Education
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We have noted that participation of all should be sought in preparing budgets; and that the budgets are prepared by line executives, though the final approval is accorded by top management. Participation can be meaningful only when people at all levels of management are convinced of the usefulness of budgets, understand the nature and characteristics of budgets, and know the role which they have to play in profit planning and control.In fact, for the success of budgeting, everyone in the enterprise should have confidence in the budgeting system and should be involved and committed to it.
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The line executives, who actually prepare the budgets, should not only be confident of their ability to plan the future with reasonable precession, but also should understand the technicalities of budgeting. They should know how to readjust budgets when the circumstances change. They should also be able to “sell” the idea of budgeting to their subordinates in order to seek their meaningful participation and involvement.This requires a continuous budget education. The employees of an enterprise must be educated about the nature, characteristics, value and methods of budgeting. They should also be taught how to interpret the budget results and how the performance is evaluated through budgets. Different methods can be used to give budget education to employees of an enterprise. Seminars, conferences, lectures, discussions, executive development programs etc. can be organized. Written material can also be distributed. The line executives who must be well conversant with the budgeting methods, maybe given on-the-job-training, explaining to them how budgets are actually prepared. Whatever may be the methodology, the basic point to be emphasized is that there should be a proper system of educating employees about various facts of budgeting to have a better involvements, commitment and participation.
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Flexibility
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The budgeting system should be flexible enough to take advantage of all opportunities that arise from time to time and are not covered by the budget. Inflexibility impairs the initiative and freedom of managers and subordinates in making decisions.Rigidly administered budgeting programme dominates the business and imposes “straight jackets” in implementing the budgets (plans).
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On the other hand, if the budgeting programme is administered in a flexible and sophisticated way, managers at all levels get greater freedom in applying the budges (plans). Infact, budgeting is a device to bring all levels of management together into the decision-making process of the enterprise. Once the budgets have been developed with full participation of all and have been approved, top management can delegate more authority and responsibility to lower levels of management and can exercise better control over them through budgets.
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In other words, budgeting allows more freedom to management at lower levels within the broad framework of budgets they are free to make decisions. Top management would exercise a tight control over lower levels of management and would put restrictions on them to make decisions in the absence of a sophisticated budgeting system.
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A flexible and comprehensive budgeting permits management to readjust plans when a new situation arises.
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The principle of flexibility is particularly significant in cost control. The expenses budgeted for and anticipated level of activity to find out the variance. For a rational answer we should compare actual expenses with budgeted expenses for the actual level of activity. Expense budgets should not be used rigidly, therefore. Variable or flexible expense, budgets are employed to make a meaningful comparison of the actual and budgeted expenses that the anticipated circumstances change.
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(b)??????????????Control: Assuring conformity of actual operations with management’s plans.
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Effective planning and control are must for good business and successful operations.
Purpose of a Budget
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·???????Estimate (blue print) of what is going to occur in the Company (A device for making and coordinating plans).
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·???????A motivating device for the employees to want to achieve (when it represents a tight but attainable goal).
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·???????A standard for evaluating actual results
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·???????Budget communicates management plans to all concerned with execution in a quantitative form.
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Benefits derived from budgets
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(a)Planning
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·???????Assist basing action upon thorough investigation study and research
·???????Allow the enlistment of the assistance of the entire organization in charting the most profitable course.
*Budgets serve as a declaration of policies
*Define objectives
*Help in establishing employment
*They promote more effective use of physical facilities.
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(b)Co-ordinating
*It helps coordinate human effort within the business structure
*Relate the activities of the business to the general trend of economic conditions
*Help to direct capital and effort into the most profitable channels by means of balanced and unified programme.
*Assist in revealing the weakness in an organization co-ordination of efforts required in communication of objectives and instructions, and a budget is one and vital means of communication.
?Control:
?Control of specific operations or expenditures
Prevent waste
A budget, carefully developed and prepared, coupled with sound organization provides a strong basis for control. But budgets will not ensure effective control unless they are prepared in a form and in terms understandable by those who are expected to have their performance measured by it.
Advantages
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Put in another way, we can derive the following advantages
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·???????Budgeting forces early consideration of basic policies
·???????Adequate and proper organization becomes a must because there must be definite assignment of responsibility for each business function
·???????All members of management become involved or participate in the establishment of goals (objectives)
·???????Departmental managements are forced to harmonize their plans with others
·???????Management is bound to demand adequate accounting data/information. This helps in making those responsible sit up.
·???????Management must plan for the most economical use of all resources
·???????The habit of timely, careful and adequate consideration of all factors before important decision is inculcated at all levels of management.
·???????Management is made to give adequate and timely attention to the effect of the trend of general business (economic) conditions.
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Limitation of Budgets
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·???????Estimates are used as a basis for the budget
·???????A budgetary programme requires continuous adaptation to fit changing circumstances. A reasonably good budgetary programme takes time to perfect or achieve.
·???????No automatic execution of a budget plan. All levels of management must be involved. This is not easy.
·???????No budgetary system can replace the need for superior executive ability to major business decisions
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Types of Budgets
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·???????Operating Budget: planned operation for a period.
·???????Cash Budget: shows anticipated sources and uses of cash.
·???????Capital Budget: planned changes in fixed asset/investments
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Operating budget can be either in the form
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1.Programme Budget – by product (Revenue vs Expenses) or line of activity (Plans in terms of major progress).
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2.Responsibility Budget – componential budget (Schedules) approach (Budgets in terms of persons responsible for executing the plans).
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The two are similar and can be used together. Budgets need not be new, decisions or plans can unfold in the budgetary process.
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Capital Budget
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Proposal must be justified. Subjective factors sometimes prevail – improved morale, safety, appearance, convenience.
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Types of Capital Projects
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·???????Replacement and cost reduction
·???????Expansion of existing product lines
·???????New products
·???????Health and safety subjective criteria used.
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Approved of capital budget is only approval in principle.
Specific authorization is generally required before work can begin on the project.
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Budget – Future Oriented
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We should all be interested and concerned with the future because, believe it or not the rest of our lives will be spent there as individuals and members of respective economic or business units.
1.Long term (long range) Budgets - Affect company expansion policy in matter of new product and the matter of investments in new plant and equipment. 5 years – 25 years.
2.Short-term – 2 – 3 years.
3.Annual – 1 year – sets forth the operating plans and profit objectives for the coming financial year.
4.Month-to-month – most effective in controlling costs, sales and sales expenses.
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Fixed Budget – prepared for one level (volume) of activity for a period. In evaluating performance, the budget is not adjusted to actual levels of activity reached (A fixed budget is subject to revision, it is fixed only in respect of level of activity).
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Flexible (Variable or sliding) Budgets constructed to show costs at various level of achievement. A more useful device for control and performance evaluation.
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Appropriation Budgets
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Peculiar to government and public service operations used by business occasionally in connection with advertisement, capital additions and research. Distinguishing characteristics is the ceiling (limitation) placed on expenditure in such budgets.
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Budgetary Control
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This is the establishment of budgets relating the responsibilities of executive to the requirements of a policy and the continuous comparison of actual with budgeted results either to secure by individual action, the objective of that policy or to provide a basis for its revision.
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Essentials of a Good Budgetary System
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·???????Complete co-operation of the chief and other top executives
·???????Ultimate motive should be to maximize profit
·???????The budget director/committee must be good salesmen
·???????Let those to operate budgets be responsible for the preparation of the estimates
·???????Budgets must cover all phases of operations
·???????Budgeting must be a continuous exercise
·???????Periodic performance/evaluation report are necessary
·???????An adequate and functional accounting system is a must.
·???????The budgetary system must rest on a good organization
·???????Good human relation is quite necessary.
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Considerations for Determination of Budget Period
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·???????For a seasonal business, include at least an entire seasonal cycle in the budget
·???????Period should be long enough to complete production of various products.
·???????Period should be long enough to allow for financing of the production well in advance of actual needs
·???????The period should coincide with the financial accounting period to facilitate comparison of actual results with the budget.
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Budget Committee Functions
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·???????Receive and review individual budget estimates (proposals)
·???????Suggest Revisions
·???????Decide on general policies affecting more than one primary deptartment (synthesis of polices)
·???????Approve budgets and later revisions
·???????Review budget performance and evaluation report
·???????Recommend necessary action
·???????Set guidelines for the organization
·???????Coordinate the componential budgets (schedules)
·???????Resolve conflicts
·???????Submit final budget for the board’s approval.