SMA UNIT 2

MEANING
"An action plan quantified in monetary terms prepared and approved prior to a defined
period of time usually showing planned income to be generated and/or expenditure to be
incurred during that period and the capital to be employed to attain a given objective. "

An analysis of this definition reveals the following essentials of a budget:

 It is a plan expressed in monetary terms, but it can also contain physical units.
 It is prepared prior to a defined period of time (budget period) during which it will
operate.
 It is related to a definite future period.
 It is approved by the management for implementation.
 It usually shows the planned income to be generated and expenditure to be incurred.
 It also shows capital to be employed during the period and
 It is prepared for the purpose of implementing the policy formulated by the
management and the objective to be achieved during the period.

MEANING OF ESTIMATE, FORECAST AND BUDGET

An estimate is predetermination of future events either on the basis of simple guesswork or
following scientific principles.
Forecast is an assessment of probable future events.
A budget is a detailed statement of forecast resulting from joint action of a number of
planned operations conducted with normal efficiency.
Difference between Budget and Forecast

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BUDGETARY CONTROL
Budgetary control is the establishment of the budgets relating to the responsibilities of
executives to the requirements of a policy and the continuous comparison of actual with
budgeted results
.
The essentials of budgetary control that are contained in this definition are :
(i) Establishment of budgets for each function and section of the organisation.
(ii) Executive responsibility in order to perform the specific tasks so that objectives of the
enterprise may be attained.
(iii) Continuous comparison of the actual performance with that of the budget so as to know
the variations from budget and placing the responsibility of executives for failure to achieve
the desired result as given in the budget.
(iv) Taking suitable remedial action to achieve the desired objective if there is a variation of
the actual performance from the budgeted performance.
(v) Revision of budgets in the light of changed circumstances.

Budget, Budgeting and Budgetary Control

Budgets are the individual objectives of a department.
Budgeting may be said to be the act of building budgets.
Budgetary Control planning the budgets and the utilisation of such budgets

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FIXED BUDGET AND FLEXIBLE BUDGET

Fixed Budget
It has been defined as. a budget which is designed to remain unchanged irrespective of
the volume of output or turnover attained. It is rigid budget and is drawn on the assumption
that there will be no change in the budgeted level of activity. It does not take into
consideration any change in expenditure arising out of changes in the level of activity.

Flexible Budget
A flexible budget (also called sliding scale budget) is a budget which, by recognizing the
difference in behavior between fixed and variable costs in relation to fluctuations in output,
turnover, or other variable factors such as number of employees, is designed to change
appropriately with such fluctuations. Thus, a flexible budget gives different budgeted costs
for different levels of activity.
A flexible budget is prepared after making an intelligent classification of all expenses
between fixed, semi-variable and variable because the usefulness of such a budget
depends upon the accuracy with which the expenses can be classified.
Where the level of activity during the year varies from period to period, either due to the
seasonal nature of the industry or to variation in demand. .
Where the business is a new one and it is difficult to foresee the demand. .
Where the undertaking is suffering from shortage of a factor of production such as
materials, labour, plant capacity etc. The level of activity depends upon the availability of
such a factor of production.

Where an industry is influenced by changes in fashion.

Where there are general changes in sales.

Where the business units keep on introducing new products or make changes in the design
of its products frequently.

Where the industries are engaged in make to order business like ship-building.

Distinction between Fixed Budget and Flexible Budget

Utility (or Importance) of Flexible Budget

1. Flexible budget provides a logical comparison of budgeted allowances with the actual
cost i.e.,a comparison with like basis. .

2. Flexible budget reckons operational realities and streamlines control function and profit
planning. It gives balanced perspective on comparison. When flexible budget is prepared,
actual cost at actual activity is compared with budgeted cost at actual activity i.e., two
things to a like basis.

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3. Flexible budget recognises concept of variability and provides logical comparison of
expenditure with actual expenditure as a means of control.

4. With flexible budget, it is possible to establish budgeted cost for any range of activity.

5. A flexible budget is very useful for purposes of budgetary control because it corresponds
with changes in the level of activity.

6. It is helpful in assessing the performance of departmental heads because their

performance can be judged in relation to the level of activity attained by the organisation.

7. Cost ascertainment at different levels of activity is possible because a flexible budget is

prepared for various levels of activity.

8. It is helpful in price fixation and sending quotations.

Zero Base Budgeting (ZBB)

This budget is the preparation of budget starting from Zero or from a clean state. As a new
technique it was proposed by Peter Payal of Texas Instruments Inc., U.S.A. This technique
was introduced in the budgeting in the state of Gorgia by Mr. Jimmy Carter who was then
the Governor of that state. When Mr. Carter later on became President of the U.S.A., ZBB
was tried in federal budgeting as a means of controlling state expenditure. The use of zero-
base budgeting (ZBB) as a managerial tool has become increasingly popular since the
early 1970s. It is steadily gaining acceptance in the business world because it is proving its
utility as a tool integrating the managerial function of planning and control.

Conventional Budgets are prepared mainly on past performance and actual costs. Thus a
conventional budget represents a quantification of the firm's objectives and the efficiency of
budgeting as a planning and control device depends upon the activity in which it is being
used. Budgets are best used as a managerial control in activities which are directly related
to the final output of the organisation because the inputs used by these activities can be
compared with the output of these activities. Thus a more accurate budget can be framed
once the relationship between inputs and outputs is established. But there are some
activities which are not directly related to the firm's output such as the legal staff and the
personnel office. A more accurate budget cannot be developed for such activities because
the tasks assigned and resources allocated to such activities are not directly related to the
finn's output and it is difficult to develop and use standard cl'>st for such activities. Zero-
base budgeting is most appropriate in controlling these staff and support areas, (i.e. non-
manufacturing overhead).

A conventional budget is developed mainly on the concept of incrementalism. Under this

approach cost levels of the previous year are often taken as a base to start within, and
budget units focus their attention on ascertaining what changes from the previous year are
required. Thus, a budget is developed on the basis of incremental changes from the
previous year's figures taken as base.

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An incremental approach to budgeting carries forward previous year's inefficiencies and
extravagances because previous year's figures are taken as a base for the development of
a budget. Thus incremental approach does not promote operational efficiency because it
does not require managers to review their past activities.
On the other hand, zero-base budgeting is not based on the incremental approach and
previous year's figures are not adopted as a base. Rather, zero is taken as a base as the
name goes. Taking zero as a base, a budget is developed on the basis of likely activities
for the future period. In ZBB, by delinkin_ the budget from the past, the past mistakes are
not repeated. Funds required for any activity for the next budget period should be obtained
by presenting a convincing case. Funds will not be available as a matter of course. Zero-
base budgeting has been defined by its originator Peter A Pyher as follows:
"A planning and budgeting process which requires each manager to justify his entire
budget request in detail from scratch (hence zero base) and shifts the burden of proof to
each manager to justify why he should spend any money at alL The approach requires that
all activities be analysed in 'decision packages' which are evaluated by systematic analysis
and ranked in order of importance."
CIMA has defined it "as a method of budgeting whereby all activities are revaluated
each time a budget is set. Discrete levels of each activity are valued and a combination
chosen to match funds available". In short an elaborate practice of having a manager justify
activities from the ground up as though they were being launched for the first time.
A unique feature of zero-base budgeting is that it tries to help management answer the
question. "Supposing we are to start our business from scratch, on what activities would be
spend our money and to what activities would we give the highest priority? Thus, zero-base
budgeting tries to overcome the weaknesses of conventiom_l budgeting, especially in those
areas where it is difficult to apply flexible budgeting. It can be successfully applied to
government expenditure and, within the business would, items of expenditure other than
direct material, labour and overheads such as research and development, data processing,
quality control, marketing and transportation, legal staff and personnel office.

Steps in ZBB .
(i) Identification of decision units in order to justify each item of expenditure in their
proposed budget.
(ii) Preparation of Decision Packages. Each package is a separate and identificable activity.
These packages are linked with corporate objectives.
(iii) Ranking of decision packages based on cost benefit analysis.
(iv) Allotment of funds based on the above resulting by following pyramid ranking system to
ensure optimum results.

Decision packages are self contained modules or proposals seeking funds. Each decision
package will clearly explain the activity, the need for the item, the amount involved, the
benefit of implementing the proposal, the loss that may be incurred, if it is not done etc.

Advantages of Zero Base Budgeting

The following are the main advantages of ZBB :
(1) Zero-base budgeting is not based on incremental approach, so it promotes operational
efficiency because it requires managers to review and justify their activities or the h.ll1ds
requested. Past efficiencies are not repeated.

(2) Zero-base budgeting is most appropriate for the staff and support areas (i.e.. non -

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manufacturing overheads) of an organisation because the inputs of these areas are not
directly related to the final outputs of the organisation.

(3) Zero-base budgeting considers every time alternative ways of performing the same job
because zero is taken as a base every time at the preparation of a budget. Thus
management has an opportunity to get a critical appraisal of its activities.

(4) It focuses management process on analysis and decision-making because it requires

managers to review their activities every time when a budget is developed..

(5) It is helpful to the management in making optimum allocation of scarce resources

because a unique aspect of zero-base budgeting is the evaluation of both current and
proposed expenditure and placing it in some order of priority. Funds are used on priority
basis and hence there is better allocation of resources.

(6) Coordination within the firm is improved and communication channels are strengthened.

(7) Increased participation in ZBB creates a motivational impact.

(8) ZBB is particularly useful for service departments and Governments.

(9) It makes managers cost conscious and helps them in identifying priorities in the overall
interest of the organisation.

To conclude, ZBB is not a panacea, but it can certainly increase the usefulness of the
budgeting process because it tries to overcome the weaknesses of conventional budgeting.

Defects of ZBB _

(i) The paper work will increase periodically due to large number of decision packages.
(ii) The cost of preparing the various packages may be very high in large firms involving
vast number of decision packages.
(iii) Ranking of packages is very often subjective and may give risk to conflicts.
(iv) Bad managers may resist new ideas and changes as they feel threatened by ZBB.
(v) Some activities may have qualitative rather than quantitative benefits as it is very
difficult to quantify such activities as research and development and general administration.
(vi) It may lay more emphasis on short term benefits to the determinent of long term
objectives of the organisation. '
(vii) Costs and benefits on each package must be continually up-to-dated to be relevant
and new packages are to be developed as soon as new activities emerge.

Inspite of these defects, ZBB was adopted by several Governments all over the world to
improve their budgeting skills. It finds application in control of service department costs. But
for control of direct costs as direct materials and direct labour expenses etc. standard
costing may be more useful.

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1. A manufacturing company submits the following figures of product 'X' for the first quarter of
2001
Sales (in units) January February March
50,000 40,000 60,000
Selling price per unit Rs. 100
Target of 1st Quarter 2002
Sales quantity increase 20%
Sales price increase 10%
Prepare Sales Budget for the first quarter of 2002.
2, A manufacturing company submits the following figures relating to Product X for the first quarter
of 2001 :
Sales Targets: January 60,000 units
February 48,000 units
March 72,000 units
Stock position: 1st January 2001 (% of January 2001 sales)
Stock position: 31st March, 2001
Stock position: end January & February
(% of subsequent Month's Sales)
You are required to prepare production budget for the first quarter of 200I

3. Prepare a material requirement budget : Estimated sales of a product-40,OOO units. Each unit
of the product requires 3 units of material A and 5 units of material B. Estimated opening balances
at the commencement of the next year: Finished product-5,OOO units; Material A-12,OOO units;
Material B-20,OOO units; Material on order-Material A-7,OOO units and Material B-1 1,000 units.
The desirable closing balances at the end of next year: Finished product-7,OOO units; Material A-
15,000 units; Material B-25,000 units; Material on orderMaterial A-8,000 units and Material B-
IO,OOO units.
Distinction between Fixed Budget and Flexible Budget
Fixed Budget Flexible Budget

Flexibility It is inflexible and does not It is flexible and can be suitably

change with the actual volume recasted quickly according to level
of output achieved. of activity attained.

Condition It assumes that conditions It is designed to change according

would remain static to changed conditions.
Classification of costs Costs are not classified Costs are classified according to
according to their variability the nature of their variability.
i.e. fixed, variable and semi-
variable

Comparison Comparison of actual and Comparisons are realistic as the

budgeted performance cannot changed plan figures are placed
be done correctly if the volume against actual ones.
of output differs.
.

Budget Only one budget at a fixed level Under it, series of budgets are
of activity is prepared due to an prepared at different levels 0 f
unrealistic expectation on the activity.
part of the management i.e., all

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 conditions will remain
unaltered.

Ascertainment of costs It is not possible to ascertain Costs can be easily ascertained at

costs correctly if there is a different levels of activity under this
change in circumstances. type of budget.
.

Tool for cost control It has a limited application and It has more applications and can
is ineffective as a tool for cost be used as a tool for effective cost
control control

. Fixation of prices & if the budgeted and actual It helps in fixation of price and
sub- mission of tenders activity levels vary, the correct. submission of tenders due to
ascertainment of costs and correct ascertainment of costs.
fixation of prices becomes
difficult.

4. The expenses budgeted for production of 10,000 units in a factory are furnished below:
Per unit in Rs.
Materials 70
Labour 25
Variable Factory Overheads 20
Fixed Factory Overheads (Rs. 1,00,000) 10
Variable Expenses (Direct) 5
Selling Expenses (10% fixed) 13
Distribution Expenses (20% fixed) 7
Administrative Expenses (Fixed - Rs. 50,000) 5
Total cost of sales per unit 155
You are required to prepare a budget for the production of 6000 units and 8,000 units.

5. The monthly budgets for manufacturing overhead of a concern for two levels of activity were as
follows:
Capacity 60% 100%
Budgeted Production (units) 600 1,000

Wages Rs 1,200 Rs. 2,000

Consumable Stores 900 1,500
Maintenance 1,100 1,500
Power and Fuel1, 600 2,000
Depreciation 4,000 4,000
Insurance 1,000 1,000
Total 9,800 12,000
You are required to :
(i) indicate which ofthe items are fixed, variable and semi-variable;
(ii) prepare a budget for 80% capacity; and
(iii) find the total cost, both fixed and variable, per unit of output at 60%, 80% and 100% capacity.

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 PROBLEMS IN VARIANCE ANALYSIS

MATERIAL COST VARIANCES

Q1) Compute material cost variances for the following data

Composition for 100 units of product
Raw Standard Actual
material
A 40 units @Rs 50 50 units @ Rs 50
B 60units @ Rs 40 60 units @ rs 45

Q2) Compute material cost variances for the following data

Raw Standard mix Actual mix
material
A 60 units amounting Rs 300 units amounting Rs 15,300
3000
B 40 units amounting Rs 200 units amounting Rs 5,600
1200

There exists a standard loss of 10% and actual output of 440 units and standard rate for the scrap
value realized is Rs 6/-

Q3) Compute material cost variances for the following data

Raw Standard mix for100kgs Actual mix for 500kgs output
material output
A 30 units @ Rs 4 140 units @ Rs 4.2
B 40 units @ Rs 5 220 units @ Rs 4.8
C 80 units @ Rs 6 440 units @ Rs 6.5

LABOUR COST VARIANCES

Q4) A manufacturing firm has the following information for producing 500 units of a product

Budgeted
50 men @ Rs 15 per hour for 32 hrs
75 women @ Rs 12 per hour for 36 hrs

Actual
46 men @ Rs 16 per hour for 32 hrs
78 women @ Rs 13 per hour for 36 hrs

Compute all labour cost variances

Q5) The details regarding composition and the weekly wages rates of the labour force engaged on
a job scheduled to be completed in 30 weeks are as follows

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 Standard Actual
Category No. of labour hrs Wage No. of labour hrs Wage rate
rate
Skilled 75 60 70 70
Semi skilled 45 40 30 50
Unskilled 60 30 80 20

The work is completed in 32 weeks. Calculate the various labour variances

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