Module 4: Budgeting and Variance Analysis

Budgeting: A Comprehensive Overview Budgeting is a critical management tool for planning and controlling organizational activities. It's an integral part of a larger planning exercise, with budgets forming part of the company's long-term vision. I. Core Concepts of Budgeting

• Definition: A budget is a plan of action, with every department preparing a budget to achieve the target set in the long-range plan.
• Purpose: Budgets ensure that resources are allocated to achieve the organization's long-term vision, which outlines what the company wants to be in the long run.
• Benefits:
  • Strategic Alignment: Budgets help in aligning departmental goals with the overall organizational goals.
  • Resource Allocation: They facilitate the effective allocation of resources based on the number of activities.
  • Performance Monitoring: Budgets provide a framework for evaluating performance and comparing actual results with planned outcomes.
  • Cost Control: They help in identifying and controlling costs, leading to improved profitability.
  • Employee Participation: Budgeting fosters employee participation, giving them a sense of ownership.
  • Problem Identification: It helps identify potential bottlenecks or areas where performance deviates from expectations.
  • Coordination: Budgets promote inter-departmental and functional coordination.
  • Communication: They serve as a means of communication, conveying plans and expectations throughout the organization.
  • Motivation: Well-designed budgets can motivate managers and employees to achieve targets. II. The Budgeting Process The budgeting process is complex and involves many facets:
• Information Gathering: It begins with gathering historical data and comparing the same to understand past performance of various budget units.
• Performance Evaluation & Incentive System: A system is created to evaluate performance based on the budget and advise managers to achieve targets.
• Preparation Approaches:
  • Imposed Budget: A top-down approach where budgets are handed down to lower levels. Often suitable for small businesses or in times of economic crisis when operating managers lack budgeting skills.
  • Participatory Budget: Prepared in consultation with managers responsible for executing the budget. This is generally preferred as it fosters greater commitment and ownership.
• Key Factor Identification: Organizations identify a 'key factor' (also known as a limiting factor or principal budget factor) that constrains output. Budgeting decisions start with this factor.
  • Functional Trade Exchange: This stage involves gaining information from each other and often bargaining for limited resources. The budget team coordinates between divisions and functions to achieve a balance.
• Data Inputs: Typical inputs and outputs of budgeting exercise include:
  • Expected and planned finished goods quantity and values.
  • Opening and closing inventory (raw materials, work-in-progress, finished goods).
  • Production schedule (raw materials, labor, equipment, machine hours, and other expenses).
  • Per unit cost drivers and monetary values.
  • Purchase and sales policy for both unit and cash costs.
  • Capital budgeting proposals.
  • Financial profit/loss statement, balance sheet, and statement of cash flows. III. Types of Budgets Budgets can be prepared in different ways to meet organizational requirements:
• Flexible Budgets: Suitable for firms with high volatility in demand, allowing them to handle different production and sales volumes without going through the entire budgeting exercise again.
• Rolling Budgets (Continuous Budgets): An ongoing budgeting exercise that continually updates. Some recent developments in budgeting emphasize this.
• Activity-Based Budgeting (ABB): Assumes a firm primarily incurs expenses due to the volume and nature of activities performed. It links budget to input and output of activities, a bundle of activities, goods, or services.
  • Steps in ABB:
    • Determine the cost of performing each unit of activity.
    • Determine sales demand and production based on the key factor.
    • Compute budgeted cost of performing each activity.
    • Consolidate the activities of the budgets.
  • Benefits: Requires a detailed listing of activities and a plan for their performance.
  • Suitability: Best suited for companies that want to achieve profit and cost goals.
• Conventional Budgeting: This is reasonably successful for operational budgets like raw material and labor. Functional budgets are prepared on a current budget year basis, testing last year's budget on an 'add on' basis.
• Zero-Based Budgeting (ZBB): Governments found it useful to prepare ZBB. It involves thoroughly examining the justification of all activities before drawing a fresh budget. The continuation of an activity is only justified if it's proven necessary.
  • Benefits: Brings certain discipline and has been useful in commercial firms, particularly R&D and service functions.
  • Relevance: Zero-based budgeting and activity-based budgeting are relevant in this context to eliminate slacks in the budget.
  • Core Principle: Requires asking fundamental questions about spending money for a particular activity.
  • Process: Each activity needs detailed estimation of costs.
  • Challenge: It is difficult to create a slack under this approach.
• Variance Analysis: Not just about numbers, but about insight and accountability, and understanding the cause of deviations.
• Master Budget: Planning is a primary objective of budgeting exercise. The final goal is extension of planning and controlling. IV. Success of Budgets and Considerations
• Success Measurement: The success of a budget is measured not only in terms of achieving physical output but also on improvement achieved during the budget.
• Flexibility: Budgets should be adaptable. If a slack is already in place, flexible budgets can be prepared for each activity.
• Leveraging Different Types: Organizations can combine different types of budgets to leverage benefits.
• Budget Document: The budget document is generally shared with the managers, who are expected to communicate it to their teams.