Budget and Budgetary Control

Budget

Budget:

         A plan which for a definite period, covers, all phases of operations in the future is known as a business budget. Policies, plans, objectives & goals are formally expressed by it & are laid down in advance for the concern as a whole & for each of its sub-divisions by the top management. Thus an overall budget will be there for the concern comprosed of several sub-budgets which are in the form of departmental budgets. Expense limitations are expressed by the budget in the expense budgets & in the sales budget, revenue goals are expressed & for the purpose of realizing the desired profit objective, these must be attained. Besides, plans relating to items such as levels of inventory, additions to capital assets, plans of production, plans of purchasing, requirements of labour, requirements of cash etc. are expressed by the budget. Thus, for a given period, budget is a formal management plans’ & policies’ statement which can be used in that period as a guide or blue print.

The basic elements of a budget are:

(a) For a specified period of time, it’s a future plan of activity,

(b) Budget can be expressed in monetary or physical units or in both,

(c) Before the period during which the budget is supposed to operate, it is prepared i.e. it is prepared in advance.

(d) Before the preparation of the budget, it is necessary to lay down the objectives which are required to be attained & the policies which are required to be pursued for the achievement of those objectives.

Budgetary Control: 

         Throughout the budget period, the use of budgets & budgetary reports for the purpose of coordinating, evaluating & controlling day-to-day operations according to the goals which are specified by the budget is involved by budgetary control. The mere presentation of budget doesn’t have much value, its real value lies in the aspects of the planning & its utilization during the period for the purposes of control & coordination. Under budgetary control, actual results are constantly checked & evaluated & comparison of actual result is made with the budgeted goals & wherever indicated, corrective action should be undertaken. The following steps are involved in the process of budgetary control:

(a) The objectives which are required to be achieved by the business should be defined & specified by budgetary control.

(b) For the purpose of ensuring that the desired objectives are accomplished, business plans are needed to be prepared by budgetary control.

(c) Budgetary control translates the plans into budgets & relates to particular sections of the budget, the responsibilities of individual executives & managers.

(d) Budgetary control constantly compares the actual results with the budget & the differences between the actual & budgeted performance are calculated.

(e) For the purpose of establishing the causes, the major differences are investigated by budgetary control.

(f) In a suitable form, budgetary control presents the information to the management, relating to variances to individual responsibility.

(g) In order to avoid a repetition of any over-expenditure or wastage, management takes corrective actions. Alternatively, where due to the change in circumstances, the budgeted targets cannot be achieved, the budget is revised.

Difference between Budget, Budgeting & Budgetary control:

         Individual objectives of a department etc. are indicated by budget, whereas the act of setting the budgets is known as budgeting. All are embraced by budgetary control & also the science of planning the budgets themselves & as an overall management tool, the utilization of such budgets, for the purpose of business planning & control are included in budgetary control. Thus, the term by budgetary control is wider in meaning & both budget & budgeting are included in by budgetary control.

Objectives of Budgetary Control:

         The objectives of budgetary control are:

(1)Compel for planning: As management is forced to look ahead, responsible for setting of targets, anticipating of problems & giving purpose & direction to the organization, this feature is the most important feature of budgetary control.

(2)Communication of ideas & plans: Communication of ideas & plans to everyone is effected by budgetary control. In order to make sure that each person is aware of what he is supposed to do, it is necessary that there is a formal system.

(3)Coordinating the activities: The budgetary control coordinates the activities of different departments or sub-units of the organization.   The coordination concept implies, for example, on production requirements, the purchasing department should base its budget & similarly, on sales expectations, the production budget should in turn be4 based.

(4) Establishing a system of control: A system of control can be established by having a plan against which progressive comparison can be made of actual results.

(5) Motivating employees: Employees are motivated for improving their performances by budgetary control.

Requisites of an effective system of budgetary control:

(a) There should be a clearly defined organizational structure where are area of responsibility is emphasized.

(b) Within the budgeting process, the employees should participate.

(c) For the purpose of relying the measurement of performance, there should be adequate accounting records & procedures.

(d) Budgetary control needs to be flexible, so that the plans & objectives may be revised.

(e) An awareness of the uses of the budgetary control system should be spread by the management.

(f) An awareness regarding the problems of budgetary control & especially the individual’s reactions to budgets should be spread by the top management.

Advantages of Budgetary control:

The advantages of budgetary control system are as follows:

(1) The objectives of the organization as a whole & the results which should be achieved by each department within this overall framework are defined by the budgetary control.

(2) When there is a difference between actual results & budget, then the extent by which actual results have exceeded or fallen short of the budget is revealed by the budgetary control.

(3) The variances or other measures of performance along with the reasons of difference between the actual results with those from budgeted is indicated by the budgetary control. Also, the magnitude of differences is established by it.

(4) As the budgetary control reports on actual performance along with variances & other measures of performance; for correcting adverse trends, a basis for guiding executive action is provided by it.

(5) A basis by which future budget can be prepared or the current budget can be revised is provided by the budgetary control.

(6) A system whereby in the most efficient way possible the resources of the organization are being used is provided by the budgetary control.

(7) The budgetary control indicates how efficiently the various departments of the organization are being coordinated.

(8) Situations where activities & responsibilities are decentralized, some centralizing control is provided by the budgetary control.

(9) The budgetary control provides means by which the activities of the organization can be stabilized, where the organization’s activities are subject to seasonal variations.

(10) By regularly examining the departmental results, a basis for internal audit is established by the budgetary control.

(11) The standard costs which are to be used are provided by it.

(12) For the purpose of paying a bonus to employees, a basis by which the productive efficiency can be measured is provided by the budgetary control.

Limitations of Budgetary Control:

The main limitations of budgetary control are:
(1) It used the estimates as a basis for the budget plan.

(2) In order to fit with the changing circumstances the budgetary programme must be continually adapted. Normally for attaining a reasonably good budgetary programme, it takes several years.

(3) A budget plan cannot be executed automatically. Enthusiastic participation is required by all levels of management in the programme.

(4) The necessity of having a management & administration will not be eliminated by any budgetary control system. The place of the management is not taken by it; rather it is a tool of the management.

Steps In Preparing A Budget

Steps in Preparing Budgets

The following steps are involved in the preparation of a budget:

1. Budget centers are needed to be established.
2. A clearly defined organizational chart is required to be prepared which will state, for each member of the management team, the functional responsibilities.
3. A budget manual is needed to be prepared.
4. A budget committee is required to be formed.  
5. The limiting factor or key factor is needed to be determined.
6. The budget period is to be selected.
7. Objectives which are to be reached by the end of the period of the budget are to be set.
8. Forecast for the period is needed to be prepared.
9. The policies of the enterprise e.g. range of product, distribution channels, per week normal hours of work, appropriation of research & development, stocks, investments etc. are needed to be determined.
10. The requirements in terms of economic quantities which are needed to meet the objectives while complying with the policies are required to be computed from the forecasts & subsequently these quantities are to be converted into monetary values. Thus this will result in an initial provisional budget.
11. With respect to the planned budget, initial budget is to be reviewed & until an acceptable budget emerges, the objectives or policies or both needs to be reviewed repeatedly.
12. The budget when gets formally accepted becomes the master budget & as such is an executive order.

Budget Centre: 

         Budget center is that section or department of the organization which for the purposes of budgetary control, is identified & separated from the rest of the sections or departments of the organization. The departmental heads works like responsibility centers. There should be a separate budget for each budget centre & also independent comparison should be made with actual.

Budget Manual:

         A budget manual is usually prepared for assisting everyone who is engaged in budgeting & budget administration. The procedures which are to be followed, the forms which are to be used & the responsibilities of various persons & the part that should be played by them in the budgeting process are specified by a budget manual.

         A budget manual is very helpful because a reference source which the persons who are involved in budgeting & budgetary control may need is provided by it.

         But there could be a radical difference between the current procedures & the written instruction in the manual; this is the danger of a budget manual.

         Hence, preparation of budget manual should be in loose leaf form so that the amendments can be made easily for keeping the manual up-to-date.

Budget Committee:

          In a large concern a frequent establishment of budget committee is needed. It is a useful device which coordinates & reviews the budget programme. The heads of the various departments or other high level executives should constitute the budget committee. It is generally advisory in nature.

The main functions of the budget committee are:

1. formulation of guidelines so that the budgets can be prepared;
2. receiving & reviewing of all the budgets;
3. suggesting of amendments & revisions;
4. approving of original, revised or amended budgets;
5. recommendation of actions which are needed to taken for the improvement of the effectiveness;
6. coordinating all the activities which are related to budgeting.

Limiting Factor:

         In each organization, some factor by which scale of its activity are being governed is always there. Such a factor is called the ‘limiting factor’, ‘key factor’ or ‘principal budget factor’. Some examples of limiting factors are below:

1. capacity of production;
2. skilled labor’s shortage;
3. material’s shortage;
4. space’s shortage;
5. low demand for market;
6. lack of capital.

         Always one factor, with this type of nature will be more dominant than the other factors but for each budget period that factor does not remain constant. However, once removal has been made of the factor which imposes limitation, that place is taken by another factor which then becomes the limiting factor.

         When the budget is being prepared, the limiting factor is one of vital importance. Generally, demand for the products & that of production capacity are the two most important factors.

         If producing 10000 units is the capacity of the production department but there is sales potential for 20000 units, then in that case excess sales potential is not of much consequence. Similarly, if selling capacity of the sales department is of 20000 units & production department has produced 35000 units, then such extra production is of no use. Therefore, the establishment of limiting factor & the limit imposed by it before the beginning of the functional budgets is very important. If level of demand is the main factor then before other functional budgets have been prepared, preparation has to be made of the sales budget. On the basis of the volume of goods that can be sold by the business, the production & other budgets should be prepared.

   Budget Period:

         The period of time for which the preparation & employment of budget is done is known as a budget period. Specifying the budget period at the outset of the preparation of the budget is necessary.
Depending upon the type of business & the uncertainties that are involved, budget periods will vary. Usually with the capital expenditure the long-range budgets are concerned, the span of which may be of five or more years. However, on the other hand, only a week or month is covered by short-term budgets e.g. cash budget. Master budgets by which an organization’s overall goals get consolidated, are usually prepared on an annual basis so that it can coincide with the financial year of the business. Annual budgets are usually sub divided into monthly or four-weekly period budget so that proper control can be exercised.

Distinction between Forecast & Budget:

         Prediction of relevant future factors by which an entity & its environment gets affected so that the preparation of planning decisions can be facilitated is defined as a forecast. Budget is a plan which is set by the organization itself as a target regarding what should happen, whereas a forecast predicts what is likely to happen. A forecast is a judgement which anybody can make whereas budget is objective of an enterprise which only the authorized management can make. Basis for the budget is prepared by the forecast. It’s not necessary that the forecast of a function needs to be well coordinated. However, good coordination among various operations & functions of an organization is needed in budgeting so that the desired results can be attained. The period covered by the forecast may range from one to five years or in case of certain types of business, even longer. However, except in case of capital expenditure, the projection of budget is rarely done for more than a year in advance & often projection is made for only three months. Control of variances from the approved plan so that the desired result may be achieved is involved in budgeting whereas no such control is involved in forecasting.

Types of Budgets

Budgets can be categorized in various ways. Let us go through the types of budgets in detail.

Functional Budgets

It relates to any function of the firm such as sales, production, cash, etc. Following budgets are prepared in functional budgets:

• Sales Budget
• Production Budget
• Material Budget
• Manufacturing Budget
• Administrative Cost Budget
• Plant Utilization Budget
• Capital Expenditure Budget
• Research and Development Cost Budget
• Cash Budget

Fixed Budget:

This budget is drawn for one level of activity and one set of conditions. 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.

Thus, it does not provide for changes in expenditure arising out of change in the anticipated conditions and activity. A fixed budget will, therefore, be useful only when the actual level of activity corresponds to the budgeted level of activity.

A master budget tailored to a single output level of (say) 20,000 units of sales is a typical example of a fixed budget. But, in practice, the level of activity and set conditions will change as a result of internal limitations and external factors like changes in demand and prices, shortages of materials and power, acute competition etc.

It is hardly of any use as a mechanism of budgetary control because it does not make any distinction between fixed, variable and semi-variable costs and provides for no adjustment in the budgeted figures as a result of change in cost due to change in level of activity. It does not provide a meaningful basis for comparison and control. It is also not helpful at all in the fixation of price and submission offenders.

Flexible Budget

         Estimation of future levels of activity with any accuracy is extremely difficult in some businesses because of presence of external incontrollable influences. For example, a business which provides luxury goods & services may be very sensitive to changes occurred in the economic climate. Weather may affect some business & prediction of weather conditions is difficult. In such cases, if comparison is done between actual results & budgeted figures, the result may be extremely misleading. It would not be clear without making detailed investigation, for example, whether either because of overspending or merely because the business activity level was above the budgeted level or both, there had arisen a large adverse cost variance. As a result, it becomes really difficult to control & appraisal of performance.

         With the preparation of a flexible budget the problem can be solved. Thus, a flexible budget can be defined as a range of budgets which covers a number of different expected levels of activity. It becomes possible to draw up an appropriate ‘flexible’ budget from the range once actual production is known, also the expenses can be set out which would be appropriate to the achieved level of activity.

         The main requirement of a flexible budget is that the analysis of expenses should be done into three distinct categories:

1. Fixed expenses, i.e. irrespective of the levels of activity, these expenses would be remaining the same.
2. Variable expenses, i.e. with the change in levels of activity, these expenses would change in proportion to that level.
3. Semi-variable expenses, i.e. analysis of these expenses into fixed & variable elements are needed to be done.

         As already stated, the advantage of flexing a budget is that, for the purposes of control & appraisal of performance, the comparison can be done of the actual performance with the flexed budget.

Financial Budget:

The functional budget by which the whole packages of budgets are summarized is made up of the five individual budgets:

1. Cash Budget: Cash budget shows in respect of various functional budgets; the requirements of cash as well as the anticipated cash receipts. It is concerned with liquidity.
2. Budgeted Profit & Loss Account: The budgeted revenues during the period gets matched with the same period’s budgeted costs & the same is reflected by the budgeted profit & loss account. It is concerned with profitability.
3. Budgeted Balance Sheet: It is concerned with the asset’s structure & the liabilities’ pattern.
4. Budgeted Fund Flow statement: In the organizations’ objective-striving endeavor’s, budgeted fund flow statement is concerned with the sources of funds & the applications of funds.
5.  Capital Budget: The capital budget is concerned with the questions relating to capacity & the direction which is strategic. The evaluation of alternative dispositions of capital funds as well as the choice of the capital structure which is the best is dealt with by the capital budget.

Constituent Elements of a Master Budget:

         A master budget comprises a number of functional & financial budgets.

Functional Budget:

Functional budget is related to a major function of the business. The usual functional budgets are:

1. Sales Budget:The sales in terms of quantity & value which are analyzed by the product, by region, by month, by salesman & by distribution channels are shown by this budget.
2. Selling Expenses Budget: The salaries & commission of salesmen’s, expenses & other related costs is included in this budget. 
3. Distribution Expenses Budget:Charges for transportation, charges for freight, warehousing, stock control, wages, expenses & related administrative costs is included in this budget.
4. Marketing Budget:Marketing budget, apart from details regarding advertising, activities related to promotion, market research, customers service, public relations & so forth; also includes a summery relating to sales, selling expenses & marketing expenses budgets.
5. Research & Development Budget:Materials, salaries, expenses, equipment & supplies & other costs which are related with design, development & technical research projects are included in research & development budget.
6. Production Budget:Production budget aims to supply specified quality of finished goods so that the marketing demands can be met. Levels of finished goods stock is specified by the distribution budget & for providing detailed production requirements this can be related with the sales budget. Following from this, consideration of a series of subsidiary budgets becomes necessary:

1. Raw Materials Budget:Appropriate attention to the desired levels of stock is paid by this budget.
2. Labour Budget:This budget ensures that at the right time the required number of employees with suitable skills & of suitable grade will be made available by the plan.
3. Manufacturing Overheads budget:Items such as consumable materials & waste disposal is covered by this budget.

7. Purchasing Budget:While preparing this budget along with the answers to the questions regarding when, where & at what price to buy & how often to buy, consideration has to given to raw materials, consumable items, office supplies & equipments & the whole range of requirements of an organization.   
8. Administration Expenses Budget: Such expenses as salaries & upkeep of office, salaries of management, stationery, telephones, depreciation, postage etc. are dealt with by this budget.
9.  Manpower Budget:An overall view of the need of the organization regarding manpower for all the areas of activity for a period of years-like manufacturing, administrative, sales, executive activities & so on, must be taken by the manpower budget

 

Flexible Budget Vs. Fixed Budget

Points	Flexible Budget	Fixed Budget
Flexibility	Due to its nature of flexibility, it may be quickly re-organized according to the level of production.	After the commencement of a period, fixed budget cannot change according to actual production.
Condition	Flexible budget may change according to change in conditions.	Fixed budget is based on the assumption that conditions will remain unchanged.
Cost Classification	Classification of costs is done according to the nature of their variability.	It is suitable for fixed costs only; no classification is done in fixed budget.
Comparison	Comparisons of actual figures with revised standard figures are done according to change in the production level of a concern.	If there is change in production level, then it is not possible to do a correct comparison.
Ascertainment of cost	It is easy to ascertain costs even at different levels of activity.	If there is change in the production level or circumstances, it is not possible to ascertain costs correctly.
Cost Control	It is used as an effective tool to control costs.	Due to its limitations, it is not used as cost control tool.

Zero Base Budgeting

 Traditionally, on the basis of the targets which have been set in the last year, budgeting is done. In the last year’s budget, certain additions & deductions are done for arriving at the figures for the current budget. Thus, in making traditional budget, we have to depend on the last year’s targets as well as on the principles of incrementalism or decrementalism, for the purpose of deciding upon the additions or deletions which are required to be incorporated in the budget figures of the previous year so that the figures of the current budget can be arrived.

         In case of Zero-base budgeting (ZBB), the assumption is made that there was no budget for the previous year & in the light of expected benefits & costs which are involved;  independent evaluation are made of the proposals of the current budget. Thus, ZBB refers to the formulation of a budget without any reference made to the previous plans & achievement but particular reference is made to the justification of the proposed resources’ allocation. This is not done only once. Whenever a budget needs to be prepared, every time, the process of budgeting should start from zero & in terms of cost-benefit analysis, the proposed allocation of resources should be justified.

         In the cases of planning & decision making, ZBB becomes ideal. Undertaking of previous type of work of which there is no previous experience is included in development planning. In these cases, on the basis of past targets which have been modified by certain additions & deletions, budgets can be prepared. On the basis of cost-benefit analysis, evaluation of every budget proposal is to be done. Identification of all proposed activities is to be done, as evaluation of decision packages is made by systematic analysis & ranking is done in order of priority. Upon the priority list, depends the decision making.

Main Features of ZBB:

          The main features of ZBB are the following:

1. As the basis of budgeting, Zero (or scratch) is taken & not the previous budgets’ targets.
2. The fund demanded has to be justified by the management of each decision unit.
3. Grouping of all proposed activities has to be done into various decision packages.
4. According to priority, the adequate evaluation & arrangement of all decision packages are done.
5. After proper evaluation, consideration has to be given to the alternative decision packages.
6. On the merits of evaluation of all decision packages including the alternative decision packages, resources are finally allocated.

Difference between ZBB & Traditional Budgeting:

 The distinction between the traditional budgeting & zero-base budgeting are the following:

1. In traditional budgeting, emphasis is given on previous level of expenditure, whereas, in ZBB, every time a budget is prepared, new economic appraisal is made.
2. Traditional budgeting is a function which is accounting oriented, whereas, ZBB is a function which is project or decision oriented.
3. For the preparation of a traditional project, rejustification of the existing programme is not needed, whereas, for the preparation of a zero-base budgeting, the justification of existing & new projects is needed to be done in the light of benefits & costs.
4. In the case of traditional budget, the justification regarding why, for a particular decision unit, a particular amount of expenditure is decided upon, is justified by the top management, whereas, in case of ZBB, the amount of expenditure is justified by the manager of the decision unit & not the top management.
5. In the case of traditional budgeting, the amount to added with or deleted from the figures of the previous budget figures is only taken into account, whereas, in case of ZBB, existing level of expenditure is appraised & the justification of future proposal for expenditure is done from different angles.
6. Preparation of a traditional budget is a simple job which is done year after year monotonously, whereas, preparation of a zero-base budgeting requires logical approach & many complex steps are involved for the establishment of logic behind a proposal.

Applicability of ZBB:

In planning & development areas particularly of the government & local bodies, ZBB is very suitably applicable. With reference to costs & benefits, thorough examination of the projects of every ministry is done. In respect of allocation of resources, upon the report of cost-benefit examination which is prepared by persons competent to do so, depends, which project of which ministry shall enjoy priority. ZBB becomes ideal in cases where the resources are limited but there are many development works which is needed to be done as in case of educational institutions, local bodies etc., because there is almost guarantee of the efficient use of limited resource.

In manufacturing concerns, for the purpose of controlling cost there are many devices like standard cost technique, work & motion study etc. The prime costs & production overhead gets controlled by these techniques because in these cases direct relationship between cost & output is there. But in manufacturing concerns production function gets supported by various other expenditures, but in these cases, relationship cannot be established between cost & output. For the application of ZBB, this area of expenditure is a suitable field. Expenditure like accounting, maintenance, electricity, rent of administrative office, postage, advertisement, research, development & many others covers this area.

Merits of ZBB:

          The following are the merits of ZBB:

1. Careful examination of all projects-whether current or future is done with reference to cost & benefits & the project which is most efficient is accepted. Thus, ZBB is always a technique which is based on logic. The current projects, only if they are logically sound & efficient, are continued.
2. For rational planning, on the cost-benefit acceptability, the most efficient ones amongst the available alternatives are chosen. The managers of decision units are required by ZBB to find out cost effective ways for the implementation of the plans. Thus, with the help of ZBB, best planning is made & cost can also be controlled with the help of ZBB.
3. In respect of both existing & future projects, cost-benefit analysis is done. Ranking of the projects is done on the basis of the result of the analysis & allocation of funds is done in order of priority. Thus, ZBB helps in getting labour efficiently allocated.
4. In ZBB, for the purpose of using the available resources of the organization, the most useful alternatives are found out. Alternative ways are taken into consideration in performing an activity also. Similarly, consideration is also given to the alternative quantum of efforts which are to be put in. These help promoting new ideas so that an activity can be performed in the best possible way. 
5. With regard to justifiability of continuing new undertaking on the basis of cost-benefit analysis, existing activities & new projects are appraised with equal importance.
6. In ZBB, reports are to be submitted by managers of all decision units on their claims of funds & justification of the claims. Thus, in the making of zero-base budget, it becomes compulsory for all managers of decision units to participate. Thus in allocation & utilization of funds, forthcoming of new ideas gets promoted by this.
7. Since in ZBB, existing activities gets appraised carefully, activities which fails to give desired results may be discontinued & thus by this way unproductive expenditure may be saved.
8. Since all managers adopt ZBB technique, they are obliged for making self evaluation of projects under their command. If there are any loopholes in the working progress, those are automatically detected & remedial measures are adopted. Efficiency in performance can be achieved by awareness of managers’ in respect of detection of errors & their rectification. 
9. Automatic motivation is created by ZBB which helps forming a management team of individuals having skills & talents.
10. Top management gets linked with medium & lower level management with the help of ZBB. Thus, speedy communication helping expediting appropriate decision-making is ensured.
11. ZBB helps in introducing & implementing ‘Management by objective’ (or MOB). The objectives of the traditional budgeting can be fulfilled using ZBB; as other objectives can as well be fulfilled with its help.

Demerits of ZBB:

         The following are the demerits of ZBB:

1. Time, energy & money is required in collecting & analyzing data of alternative future projects as well as existing activities.
2. If full co-operation amongst management staff is not forthcoming, then ZBB technique implementation becomes difficult.
3. As ideal standard of evaluation is not available, evaluation often becomes very difficult. Technical knowledge may be required in a desired manager’s evaluation which may not be available.
4. Managers are required to undergo continuous training. Implementation of ZBB cannot be expected in a right way if basis idea & objective of ZBB are not crystal clear to managers.
5. In case of ZBB, according to priority, ranking of projects need to be done. Irrational ranking of project may arise due to ego of top management (i.e. Irrespective of its merits, a project favored by the top management may be ranked high). Moreover, regarding the method of ranking which needs to be adopted, confusion may arise among the management staff.
6. Involvement of good number of individuals may be required by ZBB. Thus, complications may be created in communication system which results in difficulty in managing of the huge volume of data & voluminous paper work may be involved etc.   

Responsibility Center: Concept and Types

Any organizational or functional unit headed by a manager who is responsible for the activities of that unit is called a responsible center. The manager is responsible or accountable for the accomplishments of the tasks set in his unit.

The total organizational task is divided into sub-tasks, which are performed by different departments. In this sense, all departments in an organization are responsibility centers.

All responsibility centers use resources [inputs or costs] to produce something [output or revenues]. Typically responsibility is assigned to a revenue, expense, profit and/or investment center.

The decision usually will depend on the activity performed by the organizational unit and on the manner in which inputs and outputs are measured by organizational control system.

The organizational chart shows the sub-tasks being performed by different departments and also the tasks to be performed by each responsibility center. The size of the responsibility center will, however, is determined by the nature of the task, technology, people and the level in the organization hierarchy.

From the top management point of view, a division is a responsibility center, from the divisional management’s point of view; the market department of that division is a responsibility center. And from the marketing manager’s point of view, the sales, distribution, and advertising departments are responsibility centers.

Types of Responsibility Centers:

The following are the types of responsibility centers:

[a] Revenue Center,

[b] Expense center,

[c] Profit center, and

[d] Investment Center.

They are described below:

(a) Revenue Centers:

Revenue centers are those organizational units or segments in which outputs are measured in monetary terms but are not directly compared to input costs. The main focus of management’s efforts will be on revenue generated by it. A sales department is an example for a revenue center.

The effectiveness of the center is not judged by how much sales revenue exceeds the cost of the center. Rather budgets [in the form of sales quotas] are prepared for the revenue center and the budgeted figures are compared with the actual sales.

Generally the costs are not related to output. However, this does not mean that efforts are not taken to control costs in revenue centers. Though the management’s main focus is more on revenues, necessary attempts are made to control costs.

(b) Expense Centers:

In expense centers, inputs [cost and expenses] are measured in monetary terms but outputs are not. The main focus of the management will be on the control of the expenses or costs incurred by the responsibility center.

So budgets will be devised only for the input portion of these centers’ operations. Organizational units commonly considered expense centers include administration service, and research departments.

There are two types of expense centers namely engineered expense/costs center and discretionary expenses/costs center. Engineered costs are those for which costs can be estimated with high reliability based on the engineering or technical relationship that exists between costs and output; for example the cost of direct materials or direct labour.

Discretionary costs are those for which costs cannot be reliably estimated before hand and must depend to a large extent on the manager’s discretion. In other words, it is not possible to determine the optimum relationship between costs and outputs and the choice of relationship is quite often highly subjective and is left to the discretion of the manager.

For example, the amount spent on advertising, welfare schemes, management training, etc., cannot be determined objectively. The management has to make a judgment as to the right amount of such costs in a given situation subjectively. The discretionary costs can be varied at the discretion of the manager of the responsibility center.

There is no scientific way of determining the right amount. Other examples of discretionary costs centers are the accounting department, personnel department, research and product development, and so on.

In the case of engineering costs center the objective is to reduce costs as far as possible consistent with quality and safety standards. The budgeted costs are calculated using the technical relationship for the actual level of output. Hence, the performance can be evaluated by comprising the actual costs incurred with the budgeted costs.

The manager in charge of the center is responsible for both levels of budgeted output as well as cost efficiency. The costs should be reduced without sacrificing the quality. Traditionally, the focus of cost accounting has been on developing suitable systems for measurement of performance of engineered cost centers.

The performance of a discretionary cost center is also evaluated by comparing the actual expenses with budgeted expenses. However, the performance evaluation is on the basis of the manager’s ability to spend on the amount agreed upon. The actual should not exceed budget commitment without the knowledge of the manager. This system motivates managers to keep expenses within the budgeted level.

However, difficulties may arise in the measurement of efficiency or effectiveness since the output cannot be measured in monetary terms. Further it is difficult to set cost standards and measure financial performance against these standards. In an attempt to reduce costs, the divisional manager may cut costs by ignoring maintenance or avoiding training. But it may not be good for the company.

Similarly, the marketing manager may cut costs by reducing sales promotional and advertising expenses. But this may affect the sales and profitability of the concern in the long run. Thus, the conflict between short-run goal [cutting costs] and long-run goal [improving profitability] assumes particular importance in the evaluation of the performance of discretionary cost centers.

(c) Profit Center:

A profit center generally refers to a segment of an organization that generates revenue. It is a responsibility center, the manager of which is responsible for the amount of profits earned. In a profit center, performance is measured by the numerical difference between revenues [outputs] and expenditures [inputs].

The managers in the profit center are therefore, responsible for both revenues and costs. Such a measure is useful to determine the economic efficiency of the center and individual efficiency of the manager in charge of the center.

A profit center is created whenever an organizational segment [division/department] is given responsibility for earning a profit. In departmentalized organization in which each of the number of segments is completely responsible for its own product line, the separate divisions are considered profit centers.

Each division’s performance can be evaluated in terms of profits. Since divisional managers take all decisions relating to technology, product mixes strategies, and personnel, they may influence both revenues and expenses. The expenditure of a department’s sub-units are added and then deducted from the revenues derived from that division’s all products and services.

The net result is the measure of that division’s profitability. In non-divisionalized organizations, or within a division, individual departments may also be made into profit centers by crediting them for revenue and charging them for expenses. A manufacturing department, for example, would normally be considered as a cost center.

Allowing the manufacturing department to ‘sell’ its products at an agreed rate [called transfer price] to the sale department would be a method of making it a profit center. The difference between the transfer price and the manufacturing costs per unit would represent the manufacturing department’s profits.

(d) Investment Center:

An investment center is a responsibility center whose manager is responsible for earning a rate of return on the assets used in his responsibility center. In an investment center, the control system again measures the monetary value of inputs and outputs, but it also assesses how those outputs compare with the assets employed in producing them.

For example, divisions in an automobile manufacturing company, individual departments in a departmental store and individual branches of a multiple shop are investment centers.

It is important to realize that any profit center can also be considered an investment center, because its activities require some form of capital investment. In other words, an investment center can be considered as a special type of profit center, in which focus is also on assets employed.

However, a center’s capital investment insignificant [as a consultancy firm] or its managers have no control over capital investment; it may be more appropriately treated as a profit center. The distinguishing feature of an investment center that it is evaluated on the basis of the rate of return earned on the assets invested in that center, while a profit center is evaluated on the basis of excess revenue over expenses for the period.

Hence, it is better to designate a segment as an investment center rather than a profit center in order to enhance the utility of responsibility accounting. A segment may earn greater profits than others not because of better performance but by using more assets to earn such profits.

Performance Budgeting: Steps and Advantages

According to J. Burkhead, A performance budget is one which presents the purposes and objectives for which funds are required, the costs of the programmes proposed for achieving those objectives and quantitative data measuring the accomplishments and work performed under each programme.

In other words, PB is nothing but a method or technique of preparing and presenting budgets in relation to functions, programmes activities for cost and revenues by which physical and financial aspects of individual items are correlated.

“The PB is a budget based on functions, activities and projects which focus attention on the accomplishments, the general character and the relative importance of the Work to be done and the service to be rendered rather than the means of accomplishment such as personnel service, supplies, equipment etc. Under this system, the functions of various organisational units would be splatted into programmes of activities, sub-programmes and component schemes, etc. and estimates would be presented for each.”

In short, performance budgeting is such a budgeting system where the input costs are related to the performance of a firm.

Advantages of Performance Budget:

Performance budgeting presents the following advantages:

(a) Performance budgeting invites performance audit in the firms;

(b) It helps to attain the objectives of the firm in a scientific manner;

(c) This budgeting system motivates to improve performance since input-output relationship is maintained.

(d) Correct steps can easily be taken since continuous comparisons can be made between the target and the actual performance;

(e) In case of shortage or insufficient funds, proper allocation of funds can be made to various activities as per importance.

(f) All the activities of a firm can easily be analysed and the unimportant activities may be eliminated.

Disadvantages of Performance Budget:

The disadvantages of Performance Budgeting are:

(a) The success or failure of performance budgeting depends on a well-established accounting system.

(b) The workers and employees of an organisation are not interested rather resist it for its introduction as they are to work hard and more.

(c) It is not always possible to ascertain appropriate activity in an organisation.

(d) It invites lots of money and time and energy since various activities are expressed in physical units.

 

Steps for System of Performance Budgeting:

Steps in Performance Budgeting (PB):

The following are the fundamental aspects in performance budgeting as mentioned by the ARC (Administrative Reforms Commission):

(i) To establish a meaningful functional programme and activity classification of Government undertakings.

(ii) Financial accounting and financial management should be classified according to the classification of PB.

(iii) Evaluate suitable norms, work units of performance and cost per unit, if possible.

However, the report of the ARC uses the following items.

Functions → Programme → Activity → Project

Stages of Performance Budgeting:

The stages of PB are:

(a) Objectives:

The objectives of each individual activity should clearly be expressed — both in terms of money and in quantity which again must be matched against the long-term objective of the Government as it is primarily meant for that purpose.

(b) Classification:

The so-called activities should be classified in details in such a manner that may follow the prescribed classification system as far as possible which will help to allocate the resource in the selected activities as well.

(c) Analysis:

Before applying PB, short-term and long-term policy should be considered in order to achieve the desired goals. In this context alternative activities should also be identified in relation to costs and benefits. It is needless to mention that, after careful analysis, the activities should be implemented.

(d) Evaluation:

Whatever the activities are taken into consideration the same should be evaluated beforehand. Supporting data relating to physical, financial and economical information to select the desired activities should also be collected.

(e) Organisation:

The functions of various implementing agencies to achieve the desired goals should clearly be stated. Accounting system, financial policy should also be modified for the purpose.

Effectiveness of Performance Budgeting:

From the discussion made so far it becomes quite clear that PB is very helpful as well as useful in controlling and planning in those areas where there is scarce resources. It may be applied both in private sector and public sector undertaking, particularly in Government department. It may also be used both in trading concern as well as non- trading concern.

However, its effectiveness are:

(i) It facilitates to adopt performance audit:

(ii) It helps to make progress regarding long-term objectives.

(iii) It also helps to evaluate the progress or otherwise in time-bound activities so that remedial measures may be adopted to complete such objective.

(iv) It also helps to review the budget and also helps to take decision at all levels of management as far as possible.

(v) It matches both the financial aspect and physical aspect of various programmes and activities as well.

Difference between Performance Budgeting and Traditional Budgeting:

The Administrative Reforms Commission of India recommended in 1967 the introduction of performance budgeting in major spending departments in India. Although same initial efforts were made in this direction by the centre and some of the states, but it did not get wide acceptance.