1. Chapter Introduction
2. Budgeting: Meaning
3. Budgetary control
4. Budgetary control: Objectives
5. Budgetary Control Ratios
6. Master & Financial Budget
7. Fixed & Flexible Budget
8. Zero-based budgeting
1. Chapter Introduction:
Finance is the life blood of a business. Therefore, financial planning is of utmost significance to a businessman. Financial planning is concerned with raising funds and their effective utilization with a view to maximize the wealth of the company.
In spite of good financial plan, the desired results may not be achieved if there is no effective control to ensure its implementation. A budget is an important tool for financial planning and control. The budget represents a set of yardsticks or guidelines for use in controlling internal operations of an organization. The management, through budget, can evaluate the performance of every level of the organization. The discrepancy between planned performance & actual performance is highlighted through budgets.
2. Budgeting: Meaning:
Q. What do you understand by "Budgeting"? Mention the type of budgets that the management of a big industrial concern would normally prepare. How can computers help the management in the matter? (June 00)
What is Budget:
A budget is a plan expressed in quantitative, usually monetary term, covering a specific period of time, usually one year. In other words a budget is a systematic plan for the utilization of manpower and material resources. In a business organization, a budget represents an estimate of future costs and revenues. Budgets may be divided into two basic classes: Capital Budgets and Operating Budgets. Capital budgets are directed towards proposed expenditures for new projects and often require special financing. The operating budgets are directed towards achieving short-term operational goals of the organization, for instance, production or profit goals in a business firm. Operating budgets may be sub-divided into various departmental of functional budgets.
The main characteristics of a budget are:
1. It is prepared in advance and is derived from the long-term strategy of the organization.
2. It relates to future period for which objectives or goals have already been laid down.
It is expressed in quantitative form, physical or monetary units, or both. Different types of budgets are prepared for different purposed e.g. Sales Budget, Production Budget, Administrative Expense Budget, Raw-material Budget etc. All these sectional budgets are afterwards integrated into a master budget, which represents an overall plan of the organization.
Advantages of Budget
- It brings about efficiency and improvement in the working of the organization.
- It is a way of communicating the plans to various units of the organization. By establishing the divisional, departmental, sectional budgets, exact responsibilities are assigned. It thus minimizes the possibilities of buck passing if the budget figures are not met.
- It is a way or motivating managers to achieve the goals set for the units.
- It serves as a benchmark for controlling on-going operations.
- It helps in developing a team spirit where participation in budgeting is encouraged.
- It helps in reducing wastage and losses by revealing them in time for corrective action.
- It serves as a basis for evaluating the performance of managers.
- It serves as a means of educating the managers.
3. Budgetary control:
Budgetary Control
Budgeting is closely connected with control. The exercise of control in the organization with the help of budgets is known as budgetary control. The process of budgetary control includes:
- Preparation of various budgets
- Continuous comparison of actual performance with budgetary performance
- Revision of budgets in the light of changed circumstances
Installing a budgetary Control
The following steps may be taken for installing an effective system of budgetary control in an organization.
Organization for Budgeting: The setting up of a definite plan of organization is the first step towards installing budgetary control system in an organization. A budget manual should be prepared giving details of the powers, duties, responsibilities and areas of operation of each executive in the organization.
Responsibility for Budgeting: The responsibility for preparation and implementation of the budgets may be fixed as under:
Budget Controller: Although the chief executive is finally responsible for the budget program, it is better if a large part of the supervisory responsibility is delegated to an official designated as Budget Controller or Budget Director. Such a person should have knowledge of the technical details of the business and should report directly to the president or the Chief Executive of the organization.
Fixation of the budget period: Budget period means the period for which a budget is prepared and employed. The budget period depends upon the nature of the business and the control techniques. For example, a seasonal industry will budget for each season while an industry requiring long periods to complete work will budget for four, five or even larger number of year. However, it is necessary of control purposes to prepare budgets both for long as well as short periods.
Budget Procedures: Having established the budget organization and fixed the budget period, the actual work or budgetary control can be taken upon the following pattern:
Key Factor: It is also termed as limiting factor. The extent of influence of this factor must first be assessed in order to ensure that the budget targets are met. It would be desirable to prepare first the budget relating to this particular factor, and then prepare the other budgets. We are giving below an illustrative list of key factors in certain industries.
Industry Key factor
Motor car Sales demand
Aluminum Power
Petroleum refinery Supply of crude oil
Electro-optics Skilled technicians
Hydel power generation Monsoon
The key factors should be correctly identified and examined. The key Factors need not be of a permanent nature. In the long run, the management may overcome the key factors by introducing new products, by changing material mix or by working overtime or extra shifts etc.
Making a forecast: A forecast is an estimated of the future financial conditions or operating results. Any estimation is based on consideration of probabilities. An estimate differs from a budget in that the latter embodies an operating plan of an organization. A budget envisages a commitment to certain objectives or targets, which the management seeks to attain on the basis of the forecasts prepared. A forecast on the other hand is an estimate based on probabilities of an event. A forecast may be prepared in financial or physical terms for sales, production cost, or other resources required for business. Instead of just one forecast a number of alternative forecasts may be considered with a view to obtaining the most realistic overall plan.
Consideration of alternative combination of forecasts: Alternative combinations of forecasts are considered with a view to contain the most efficient overall plan so as to maximize profits. When the optimum-profit combination of forecasts is selected, the forecasts should be regarded as being finalized.
Preparing budgets: After the forecasts have been completed the preparation of budgets follows. The budget activity starts with the preparation of the sales budget. Then production budget is prepared on the basis of sales budget and the production capacity available. Financial budget (i.e., cash or working capital budget) will be prepared on the basis of sales forecasts and the production budget. All these budgets are combined and coordinated into a master budget. The budget may be revised in the course of the financial period if it becomes necessary to do so in view of the unexpected developments, which have already taken place or are likely to take place.
Choice between fixed and flexible budgets: A budget may be fixed or flexible. A fixed budget is base on a fixed Volume of activity. It may lose it s effectiveness in planning and controlling if the actual capacity utilization is different from what was planned for any particular unit of time e.g., a month or a quarter. The flexible budget is more useful for changing levels of activity as it considers fixed and variable costs separately fixed costs as you are aware, remain unchanged over a certain range of output. Such costs change when there is a change in capacity level.
The variable costs change in direct proportion to output. If flexible budgeting approach is adopted, the budget controller can analyses the variance between actual costs and budgeted costs depending upon the actual level of activity
STEPS IN BUDGETARY CONTROL
- Organization for budgeting
- Budget manual + Theory
The budget manual is a written document or booklet that specifies the objectives of budgeting organization and procedures. Following are some of the important matters covered in a budget manual:
- A statement regarding the objectives of the organization and how they can be achieved through budgetary control.
- A statement regarding the functions and responsibilities of each Executive by designation both regarding preparation and execution of budgets.
- Procedures to be followed for obtaining the necessary approval of budgets.
- The authority of granting approval should be stated in explicit terms.
- Whether one, two or more signatures are to be required on each document
should also be clearly stated.
- Timetable for all stages of budgeting.
- Reports, statements, forms and other records to be maintained.
- The accounts classification to be employed. It is necessary that the framework within which the costs, revenues and other financial amount are classified must be identical both in accounts and the budget departments.
The methods and procedures of budgetary control are standardized.
There is synchronization of the efforts of all which result in maximization of the profits of the organization.
CLASSIFICATION OF BUDGETS
Budgets can be classified into different categories on the basis of time, function or flexibility. The different budgets covered under each category are shown
Chart : Classification of Budgets
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Time |
Function |
Flexibility |
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Long Term |
Sales |
Fixed |
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Short Term |
Production |
Flexible |
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Current |
Cost of Production |
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Rolling |
Purchase |
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Personnel |
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Research |
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Capital Expenditure |
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Cash |
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Master |
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Capital Expenditure Budget: The budget provides guidance as to the amount of capital that may be needed for procurement of capital assets during the budget period. The budget is prepared after taking into account the available productive capacitates probable reallocation of existing assets and possible improvement in production techniques. If necessary separate budgets may be prepared for each item o assets, such a building budget, a plant and equipment budget etc.
Research and Development Budget: Research and development costs are to be incurred so that the products or the methods of the concern do not become out of date. The research and development budget is a forecast of all such expenses.
Sales budget: Sales budget generally forms the fundamental basis on which all other Budgets are built. The budget is based on projected sales to be achieved in a budget period. The sales manager is directly responsible for the preparation and execution of this budget. He usually takes into consideration the following organizational and environmental factors while preparing the sales budget.
It is desirable to break up the entire sales budget on the basis of different products, time periods and sales areas or territories.
Description
1. Past sales figures and trend: The record of previous experience forms the most reliable guide as to future sales as the past performances related to actual business conditions. However, the other factors such as seasonal fluctuations, growth of market, trade cycles etc., should not be lost sight of.
2. Salesmen's estimates: Salesmen are in a position to estimate the potential demand of the customers more accurately because they come in direct contact with the customers. However, proper discount should be making for over-optimistic or to conservative estimates of the salesmen depending upon their temperament.
3. Plant capacity: It should be the endeavor of the business to ensure proper utilization of the plant facilitates and that the seal budget provides an economic and balanced production on the factory.
4. General trade prospects: The general trade prospects considerably affect the sales. Valuable information can be gathered in this connection from trade papers and magazines.
5. Orders on hand: In case of industries where production is quite a lengthy process, orders on hand also have a considerable influence in the amount of sales.
6. Proposed expansion of discontinuance of products: It is affects sales and therefore, it should also be considered.
7. Potential market: Market research should be carried out for ascertaining the potential market for the company's products. Such an estimate is made on the basis of expected population growth, purchasing power of consumers and buying habits of the people.
8. Availability of material and supply: Adequate supply of raw materials and other supplies must be ensured before drafting the sales program.
9. Financial aspects: Expansion of sales usually requires increase in capital outlay also, therefore, sales budget must be kept within the bounds of financial capacity.
10. Other factors
a. The nature and degree of competition within the industry;
b. Cost of distributing goods;
c. Governments controls, rules and regulations related to the industry;
d. Political situation: national and international as it may have an influence upon the market.
e. Seasonal fluctuations
Production Budget :This budget provides an estimate of the total volume of production Distributed product-wise with scheduling of operations by days, weeks and months, and a forecast of the inventory of finished products. Generally, the production budget is based on the sales budget. The responsibility for the overall production budget ties with works manager and that of with departmental works managers.
Production budget may be expressed in physical or financial terms or both in relation to production. The production budgets attempt to answer questions like
- What is to be produced?
- When is to be produced?
- How is to be produced?
- Where it is to be produced?
Production costs budgets: Basically, there are three elements of costs, namely direct material, Direct labor and overheads. Separate budgets for each of there elements has to be prepared.
The direct materials budget has two components, (i) Materials Requirement budget, (ii) Materials procurement or purchase budget. The former deals with the total quantity of materials required during the budget period, while the latter deals with the materials to be acquired from the market during the budget period. Materials to be acquired are estimated after taking into account the closing and the opening inventories and the materials from which orders have already been placed.
Overhead budget: The overheads may relate to factory, general administration, sales and distribution function. Separate budgets may, therefore, be prepared for factory overheads, administrative overheads and selling and distribution overheads.
Manufacturing overheads budget: Factory or manufacturing overheads includes the cost of indirect material, indirect labor and indirect expenses. Manufacturing overheads may be classified into
1. Fixed overheads i.e., which tend to remain constant irrespective of change in the volume of output,
2. Variable overheads i.e., which tend to vary with the output,
3. Semi-variable overheads, i.e., which are partly variable and partly fixed. The manufacturing overhead budget will provide an estimate of these Overheads to be incurred during the budget period.
Fixed manufacturing overhead can be estimated on the basis of past Information and knowledge of any changes which may occur during the ensuring budget period. Variable overheads are estimated after considering the scheduled production and operating conditions in the budget period.
Administrative overheads budget: This budget covers the administrative expenses including the salaries of the managerial staff. A careful analysis of the needs of all administrative departments of the enterprise is necessary.
Selling and distributing overhead budget: This budget includes all the expenses relating to selling, advertising, delivery of goods to customers’ etc. It is better if such costs are analyzed according to products, types of customers, territories and the sales departments. The responsibility of the preparation of this budget rests with the executives of the sales expected and an effort should be made to control the costs of distribution. The preparation of the budget would depend on analysis of the market situation by the management, advertising policies, research programs, and the fixed and variable elements.
Cash budget
The cash budget is a summary of the firm's expected cash inflows and outflows over a particular period of time. In other words, cash budget involves a projection of future cash receipts and cash disbursements over various time intervals.
A cash budget helps the management in:
- Determining the future cash needs of the firm.
Planning for financing of those needs.
Exercising control over cash and liquidity of the firm.
- Receipts and payments method
- The adjusted profit and loss method
- The balance sheet method
The adjusted profit and loss method: In case of this method the cash Budget is prepared on the basis of opening cash and bank balances, projected profit and loss account and the balances of the various assets and liabilities.
The balance sheet method: With the help of budgeted balances at the End except cash and bank balances, a budgeted balance sheet can be prepared and the balancing figure would be the estimated closing cash/bank balance. Thus, under this method, closing balances other than cash/bank will have to be found out first to be put in the budgeted balance sheet. This can be done, by adjusting the anticipated transactions of the year in the opening balances.
4. Budgetary control: Objectives:
Q. What do you mean by Budgetary control? State its objectives. (Dec. 02)
Please refer to the previous question for details.
Objectives
- To provide a detailed plan of action for a business over a period of time.
- To coordinate the different units & activities of the organization with a view to utilize the resources judiciously.
- To revise the budgets in the light of changed circumstances.
- To exercise control and on cost through comparison of actual results with the budgeted one.
5. Budgetary Control Ratios:
Q. Discuss the budgetary control ratios and how they are calculated? (Dec. 02)
The following are the three budgetary control ratios:
Activity ratio: It is a measure of the level of activity attained over a period of time. It is obtained by expressing the number of standard hours equivalent to the work produced as a percentage of the budgeted hours.
Mathematically
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Activity ratio |
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Standard hours for actual production |
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Budgeted hours |
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Mathematically
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Capacity Ratio |
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Actual hours worked |
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Budgeted hours |
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Mathematically
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Efficiency Ratio |
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Standard hours for actual production |
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Actual hours worked |
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6. Master & Financial Budget:
Q. Distinguish between Master budget and Financial budget. How does management make use of master budget? Explain the utility of computers in this respect. (Dec. 99)
A budget is a statement, which shows forecasts of the financial activities of a business to achieve a specific purpose. A budget is basically an estimate of receipts and payments of revenue and capital items in future.
Master Budget:
Master budget (also known as summary budget or finalised profit plan) combines all the budgets for a period into one harmonious unit and thus, it show the overall budget plan. As profit planning is the main objective of a budget program, it is but natural that all the subsidiary budgets should be co-ordinated and projected into a master or summary budget, which should show the final projected results of the plan. The master budget incorporates all the subsidiary functional budgets and the budgeted Profit and Loss Account and Balance Sheet. Before the budget plan is put into operation, the master budget is considered by the top management and revised if the -position of profit disclosed therein is not found to be satisfactory. After suitable revision is made, the master budget is finally approved and put into action.
Another view regards the budgeted Profit and Loss Account and the Balance Sheet as the master budget. The Profit and Loss Account is built up from the other budgets already set, and no fresh estimates are necessary. The budgeted cost of production is deducted from the budgeted sales revenue in order to arrive at the budgeted gross profit. The operating profit is obtained by further deduction of the budgeted selling and distribution expenses. Addition and subtraction of other budgeted income and expenditure items give the budgeted net profit.
The advantages of a forecast Profit and Loss Account are as follows:
(1) It presents an overall projected profit position of the concern.
(2) It enables the planning and control of the profits of the business.
(3) It enables the investigation of causes for variances.
(4) The accuracy of all the budgets is automatically checked.
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Profit/Turnover |
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Current ratio |
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Liquidity ratio |
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- It reveals the overall financial position of the concern so that management may take action to improve it. The various forecast Balance Sheet ratios would be of assistance to the management in assessing the position.
- It enables a check to be exercised on the other budgets.
- The budgeted return on capital employed may be determined.
Forecast Profit and Loss Account
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31st October |
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Financial budget is a summary statement for the future that shows the estimated requirements of cash inflow and outflow.
According to Walker, " A financial budget is a comparison of estimated cash inflows and outflows for particular period i.e. a month, a quarter or year."
According to Guttman and Dougal, " financial budget is an estimate of cash receipts and disbursements for a future period of time."
Utility and Significance of Cash Budget
- Financial budget helps in planning of cash requirements that a business need over a period of time.
- Financial budget helps in keeping a check on the execution of the management policies.
- Financial budget helps to know whether cash expenditure items can be financed internally or not.
- Financial budget reveals shortage of cash so that it can be arranged by overdraft.
- Financial budget also enables the management to ascertain the possibility of financing the capital expenditure projects internally.
- Financial budget helps the management in knowing existing and anticipating cash resources and their utilisation.
- Financial budget reveals surplus of cash so that it may be invested properly.
- The receipts and payments method
- The adjusted profit & loss method
- The balance sheet method
Receipts and Payment Method
Under receipts and payment method estimate of cash receipts and cash payments is worked out during the budgeted period. Estimated cash receipts are added to opening cash balance and estimated cash payments are deducted out of the total. Thus, the closing cash balance is worked out. Estimates regarding sales are indicated by the sales department that also points out the general trend of credit allowed to customers. Purchase department makes forecast about the cash and credit purchases and also points out the period after which the credit purchases are met.
Estimates regarding fixed charges and variable cost are made on the basis of past experience.
Format of Financial Budget
Financial Budget
for the months of --- and --- 20—
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May
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June
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Opening Cash and Bank Balance |
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Trading Payments: |
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Cash Purchases |
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Labour Cost |
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Factory Overheads |
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Closing Cash and Bank Balance (Total Receipts – Total Payments) |
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The Adjusted Profit & Loss Method: - Financial budget under this method is also known as cash flow statement. This method is useful for long term planning, therefore under this method cash inflow and outflow are estimated for a year.
Balance Sheet Method: - Under this method the business concern prepares a budgeted balance sheet. Cash and Bank Balance (or overdraft) is computed with this budgeted balance sheet. Budgeted
Balance sheet is prepared with all assets items (excluding cash and bank balance) and all liabilities (excluding bank overdraft).
Utility of Computers
Computers are very helpful for various accounting operation such as invoicing, calculation of wages, maintaining accounts, collection of money from customers, maintaining assets, cahs book, etc. With the help of computer, a business concern can have better control over its operations. Computers may be used for credit control, budgetary control, inventory control, etc.
7. Fixed & Flexible Budget:
Q. What is a flexible budget and how it is different from Fixed budget? Explain the utility of computers in preparing budget. (Dec. 01)
Fixed Budget: A fixed budget is designed to remain unchanged irrespective of the level of activity. This budget is prepared on the basis of a standard or fixed level of activity. This budget becomes an unrealistic yardstick in case the level of activity actually attained does not conform to the one assumed for budgeting purposes. Due to the limitations of fixed budgeting, firms whose sales and production cannot be accurately estimated have given up the practice of fixed budgeting.
Flexible Budget: A budget that is designed to change in accordance with the level of activity attained is called a flexible budget. This budget is prepared after considering the fixed and variable elements of cost and the changes that may be expected for each item at various levels of operations. Flexible is desirable in the following cases:
- Sales are unpredictable, e.g., luxury or semi-luxury products.
- The venture is new & it is difficult to foresee the demand, e.g., fashion products.
- Where the business is subject to the vagaries of nature, such as soft drinks.
- Government interference, e.g., cigarettes, liquor, etc.
Utility of Computers
- Computers facilitate the Budget preparation work, which is otherwise a lengthy clumsy and cumbersome exercise.
- Since budget represents an estimate of future costs and revenues. Correct and accurate estimations can be made with the help of computers.
- Accuracy in various Budget Calculation exercise can be achieved with the help of computers.
- Time saving fast speed working, flexible budget preparing and Budgetary Control exercise can be implemented with the help of latest software package in computers.
- Control Ratios may be computed accurately with the help of computers.
8. Zero-based budgeting:
Q. What do you understand by Zero-based budgeting? (June 98, Dec.00)
Zero-based budgeting:
The technique of zero base budgeting provides a solution for overcoming the limitations of traditional budgeting by enabling top management to focus on priorities, key areas and alternatives of action throughout the organisation. .
Some of the problems, which top management has to face are:
- Programs and activities involving wasteful expenditure are not identified, resulting in avoidable financial and other costs.
- Inefficiencies of a prior year are carried forward in determining subsequent years' levels of performance.
- Managers are not encouraged to identify and evaluate alternative means of accomplishing the same objective.
- Decision-making is irrational in the absence of rigorous analysis of all proposed costs and benefits.
- Key problems and decision areas are not highlighted. Thus, no priorities are established throughout the organisation.
- Managers tend to inflate their budget requests resulting in more demand for funds than their availability. This results in recycling the entire budgeting process.
Zero base budgeting, as the term suggests, examines or reviews a program or function or responsibility from 'scratch', The reviewer proceeds on the assumption that nothing is to be allowed. The manager proposing the activity has, therefore, to justify that the activity is essential and the various amounts asked for are reasonable taking into account the outputs or results or volume of activity envisaged. No activity or expense is allowed simply because it was being allowed or done in the past. Thus, according to this technique each program, whether new or existing, must be justified in its entirety each time a new budget is formulated. It involves:
- dealing with practically all elements of managers' budget requests
- critical examination of ongoing activities along with the newly proposed activities
- providing each manager a range of choices in setting priorities in respect of different activities and in allocating resources
Process of Zero-Base Budgeting
The following steps are involved in zero base budgeting:
Determining the objectives of budgeting: The objective may be to effect cost reduction in staff overheads or it may be to drop, after careful analysis, projects which do not fit into achievement of the organizations objectives etc.
Deciding on scope of application: The extent to which the zero base budgeting is to be introduced has to be decided, i.e. whether it will be introduced in all areas of the organization’s activities or only in a few selected areas on trial basis.
Developing decision units: Decision units for which cost - benefit analysis is proposed have to be developed so as .to arrive at decisions whether they should be allowed to continue or be dropped. Each decision unit, as far as possible should be independent of other units so that it can be dropped if the cost analysis proves to be unfavorable for it.
Developing decision packages: A decision package for each unit should be developed. While developing a decision package, answers to the following questions would be desirable:
- Is it necessary to perform a particular activity at all? If the answer is in the negative, there is no need to proceed further.
- How much has been the actual cost of the activity and what has been the actual benefit both in tangible as well as intangible forms?
- What should be the estimated cost of the level of activity and the estimated benefit from such activity?
- Should the activity be performed in the way in which it is being performed and what should be the cost?
- If the project or activity is dropped, can the unit be replaced by an outside agency?
Advantages of zero base budgeting
- It provides the organisation with a systematic way to evaluate different operations and programs undertaken. It enables management to allocate resources according to priority of the programs.
- It ensures that each and every programme undertaken by managers is really essential for the organisation, and is being performed in the best possible way.
- It enables the management to approve departmental budgets on the basis of cost-benefit analysis. No arbitrary cuts or increases in budget estimates are made.
- It links budgets with the corporate objectives. Nothing will be allowed simply because it was being done in the past. An activity may be shelved if it does not help in achieving the goals of the enterprises.
- It helps in identifying areas of wasteful expenditure and, if desired, it can also be used for suggesting alternative courses of action.
- It facilitates the introduction and implementation of the system of 'management by objectives'. Thus, it can be used not only for fulfillment of the objectives of traditional budgeting, but also for a variety of other purposes.