The following points highlight the nine types of budget. The types are:
1. Plant Utilisation Budget
2. Production Cost Budget
3. Direct Material Budget
4. Capital Budgeting
5. Zero Base Budgeting
6. Performance Budget
7. Sales Budget
8. Cash Budget
9. Flexible Budget.
Plant utilisation budget is prepared in terms of working hours, weight or other convenient units of plant facilities required to carry out the programme laid down in the production budget.
The objectives of Plant Utilisation Budget are:
(i) To determine the load on each process, cost or groups of machines for the budget period;
(ii) To indicate the process or cost centers which are overloaded so that corrective action can be taken;
(iii) To dovetail the sales, production budgets where it is not possible to increase the capacity of any of the overloaded processes;
(iv) To make effort to boost sales to utilise the surplus capacity.
A product Cost Budget is the summary of material budget, labour budget, factory overhead budget.
A Production Cost Budget is also known as Manufacturing Budget that consists of three budgets namely:
(i) Material budget,
(ii) Labour budget, and
(iii) Factory overhead budget.
Direct Material Budget indicates the cost of direct material purchased.
The direct material budget is useful for the following reasons:
1. It helps the purchase department to prepare a schedule to ensure supply of material to the production departments as and when materials are required for production.
2. It helps the store department in fixing maximum and minimum levels of inventories.
3. It also helps the finance manager to ascertain the financial requirements to finance production targets.
Direct Material Budget consists of:
1. Material Usage Budget,
2. Purchase Budget.
The following example will clarify the matter.
In the words of R.M. Lynch, “Capital budgeting consists in planning for development of available capital for the purpose of maximizing the long-term profitability of the firm”.
Charles T. Horngren defines Capital Budgeting as “A long-term planning for making and financing proposed capital outlays”.
Gitman L.J. has put, “Capital Budgeting refers to the total process of generating, evaluating, selecting and following up of capital expenditure alternatives”.
The capital budgeting decision, therefore, involves a current outlay or series of outlays of cash resources in return for anticipated flow of future benefits.
Capital budgeting decision are of paramount importance in financial decision making.
Firstly, capital budgeting decisions affect the profitability of the firm. They also have a bearing on the competitive position of a firm.
Capital budgeting decisions determine the future destiny of a company. An opportune investment decision can result in a spectacular returns while an irrational investment decision can endanger the very survival of the firm.
Secondly, a capital expenditure decision has its effect over a long time span and inevitably affects the company’s future cost structure.
Thirdly, capital expenditure decisions once made and implemented are not easily reversible without much financial loss.
Finally, It involves costs. Since most of the firms have scarce capital resources there is need for wise, thoughtful and correct investment decisions.
Advantages of Capital Expenditure Budget:
Capital Expenditure Budget offer the following advantages:
(i) It highlights the capital development programmes and estimated capital expenditure during the budget period.
(ii) It provides a tool for controlling capital expenditure.
(iii) It enables the company to establish system of priorities in expenditure.
(iv) It provides some of the fixed-asset figures that will be required for the forecast Balance Sheet.
Zero Base Budgeting is an operating planning and budgeting process which requires each manager to justify his entire budget requests in detail from scratch. Each manager has to justify why he should spend any money at all. This approach requires that all activities be identified as decision on packages which would be evaluated by a systematic analysis and ranked in order of importance.
Leonard Merewit has defined ZBB as a “technique which complements and links the existing planning, budgeting and review process. It identifies alternatives and efficient methods of utilizing limited resources in effective attainment of selected benefits. It is a flexible management approach which provides a credible rationale for re-allocating resources by focusing on a systematic review and justification of the funding and performance levels of current programmes or activities”.
Devid Heminger has also explained ZBB as “a management tool which provides a systematic method for evaluating all operations and programme, current or new, allows for budget reductions and expansions in a rational manner and allows re-allocation of resources from low to high priority programmes”.
The above definition of ZBB suggests to examine a programme or function or responsibility from ‘scratch’. The evaluator proceeds on the assumption that nothing is to be allowed simply since it was being done previously. The manager proposing the activity has to justify that the activity is essential and the outlay proposed is reasonable and rational in the present circumstance.
The ZBB technique suggests that an organization should not only make decisions about the proposed new programmes but it should also, from time to time, review the ‘utility’ and appropriateness of the existing programmes.
Stages of Zero Base Budgeting:
1. Corporate objectives should be established and laid down in detail.
2. Each separate activity of the organization is identified and called decision package. A decision package is a document that identifies each activity and describes it in such a fashion so that management can (i) evaluate it and rank it against other activities competing for limited and scarce resources, and (ii) decide to approve or disapprove it.
3. Budget staff will compile operating expenses for packages approved by the departmental head.
Advantages of Zero Base Budgeting:
Zero Base Budgeting has some distinct advantages, some of them are outlined below:
(i) The proposals for funds are strictly considered on merit basis and funds are allocated on the basis of priority.
(ii) This technique motivates managers to evolve cost effective ways of performing jobs. New ideas also emerge.
(iii) Obsolete operations and wastages are identified and eliminated.
(iv) Decision packages improve coordination within the firm and strengthen communication between different departments.
(v) Managers become aware of the value of inputs helping them to identify priorities.
(vi) Zero Base Budgeting is particularly useful in areas like service departments where it is often difficult to identify and quantity output.
(vii) ZBB aims at motivating the staff to take greater interest in the job because it involves staff in decision taking process.
(viii) ZBB is useful especially for service departments where it may be difficult to identify output.
Disadvantages of Zero Base Budgeting:
(i) It is very expensive because the costs involved in preparing a vast number of decision packages in a large firm are very high.
(ii) Since more managers are involved in this process administration and communication of ZBB process may turn complicated.
(iii) Managers develop fear and feel threatened by ZBB and, therefore, may oppose new ideas and changes.
(iv) It involves a large amount of paper work and is very time consuming.
(v) The ranking of decision packages and allocation of resources is subjective to a certain degree that may lead to departmental conflict.
Traditional budgeting does not provide a link between inputs in financial terms and output in physical terms. The term ‘Performance Budget’ was originally used in U.S.A. by the first Hoover Commission in 1949 when it recommended the adoption of a budget based on functions, programmes and activities.
A performance budget is a work plan which expresses for achievement in respect of various responsibility levels based on accepted norms and standards. The National Institute of Bank Management, Mumbai has defined the performance budgeting technique as “the process of analysing identifying, simplifying and crystallizing specific performance objectives of a job to be achieved over a period, within the frame work of organisational objectives, the purposes and objectives of the job. The technique is characterised by its specific direction towards the business objectives of the organisation”.
The above definition lays stress on the achievement of specific goals over a period of time. The technique of performance budgeting calls for preparation of periodic performance reports which compare budget and actual performance to locate existing variances. Their preparation is greatly facilitated if the authority and responsibility for the incurrence of each cost element is clearly defined within the firm’s organisational structure.
Sales Budget is one of the functional budgets. Since sales forecast is the starting point of budgeting, sales budget assumes primary importance. The sales budget represents the total sales in physical quantities and values for a future budget period. Here the quantity that can be sold is the key factor for many business undertakings.
The purpose of sales budget is not to estimate or guess what the actual sales will be, but rather to develop a plan with clearly defined objectives towards which operational efforts are directed.
Factors to be considered for preparing the Sales Budget:
The following factors are to be reckoned for preparing the sales budget:
(a) Reports of the salesmen who have the first hand information about the present market conditions for the product.
(b) General economic and political conditions are to seriously studied.
(c) Relative product profitability.
(d) Pricing policies.
(e) Market Research studies providing information like changes in fashion, tastes, consumers’ preference, purchasing power of the consumers, and competitions’ activities etc.
(f) Seasonal and cyclical variations.
(g) Advertising and sales promotion and their impact on the product market.
(h) Production capacity of the plant etc.
The Sales Budget may be prepared under the following classification or combination of classifications:
(a) Products or groups of products,
(b) Areas, Towns, Salesmen, and Agents,
(c) Types of customers like government, Export, Home Sales, Retail depots,
(d) Period: months weeks etc.
A production budget incorporates the estimates of the total volume of production with the scheduling of operations by days, weeks and months. The production manager is responsible for the preparation of production budget. It is normally prepared in quantitative terms as units of output, tones of production. It is to be noted that sales budget should be used as basis for production estimates and forecasts.
The sales director of a manufacturing company reports that next year he expects to sole 50,000 units of a certain product.
The production manager consults the storekeeper and costs his figures as follows:
Two inside of raw materials A and B are required for manufacturing the product. Each unit of the product requires two units of A and three units of B. The estimated opening balances at the commencement of the next year are: Finished product 10,000 units: A 12,000 units; B 15,000 units.
The desirable closing balances at the end of the year are:
Draw up a quantitative chart showing the Material Purchase Budget for the next year.
From the following particulars, prepare a production budget for the year 2001 assuming sales as limiting facts:
Stock of B and C is to be maintained at 20% above the existing level to sustain the budgeted sales. Stock level of A may be reduced by 10%. Stock of E is proposed to be raised by 40,000 units for export market not considered in sales budget given above.
The following are the estimated sales of a company for eight months ending 30.11.1998:
As a matter of policy, the company maintains the closing balance of finished goods and raw materials as follows:
Every unit of production requires 2 kg. of raw materials costing Rs.5 per kg.
Prepare Production Budget (in units) and Raw material purchase Budget (in units and cost) of the company for the half year ending 30th September 1998.
The Cash Budget is one of the most important budgets to be prepared. It represents the cash requirements of the business during the budget period.
It contains detailed estimates of cash receipts (cash inflows) and disbursements (cash outflows) either for the budget period or some other specific period. It is a useful tool in cash management of organisations as it reveals potential cash shortages as well as potential excess cash.
Objectives of Cash Budget:
Cash budget is prepared with the following objectives:
(i) It indicates the cash availability for taking advantage of cash discount.
(ii) It indicates the cash requirement needed for capital expenditure for business expansion.
(iii) It determines the amount of loan to be taken from banks to manage working capital for a short period.
(iv) It shows the availability of excess funds for short-term investments to increase income of the organisation.
(v) Cash Budget helps the management in planning the financial requirements of bond redemption, payments to pension and retirement funds.
(vi) Efficient cash management is possible if cash budget is prepared.
Cash budgets help management to avoid having unnecessary idle cash on the one hand, and unnecessary ‘nerve-racking’ cash deficiencies, on the other.
Before discussing flexible budget it seems to be appropriate to highlight upon fixed budget. According to ICMA, London, “a fixed budget is a budget designed to remain unchanged irrespective of level of activity actually attained”. Thus, a budget prepared for fixed level of activity is known as fixed budget.
In fixed budgetary control, the budgets prepared are based on one level of output, a level which has been carefully planned. In fact, fixed budget presents expected sales revenue, costs and profits or losses for a definite level of activity, a level which has carefully been planned to equate sales and production at the most profitable rate.
Significantly, targets of fixed budget do not change with the changes of level of activity. It is true; in some companies it becomes extremely difficult to forecast sales with even a reasonable chance of success.
This situation may arise in case of following companies:
(i) Companies that are greatly affected by weather condition, e.g., the soft drink industry;
(ii) Which frequently introduce new products, e.g. the food camping industry;
(iii) Companies in which production is carried out only when order is received, e.g. shipbuilding industry;
(iv) Companies that are affected by changes in fashion; and
(v) Where large output is intended for export, e.g. production of consumers’ goods.
Definition of Flexible Budget:
The I.C.M.A. defines flexible budget as, “budget which is designed to change in accordance with the level of activity actually attained”.
The flexible budget (also called variable budget) is based on knowledge of cost behaviour pattern. It is prepared for a range, rather than a single level of activity. It is essentially a set of budgets that can be tailored to any level of activity. Ideally, the flexible budget is compiled after obtaining a detailed analysis of how each cost is affected by changes in activity.
In fixed budgetary control, the budget is prepared on the basis of one level of output, a level which has been carefully planned to equate sales and production at the most profitable rate. But if the level of output actually achieved differs considerably from that budgeted, large variances will arise. In some companies it seems extremely difficult to forecast sales with even a reasonable chance of success.
This situation may arise in case of the following companies:
(i) Companies greatly affected by weather conditions, e.g. there is a great demand of cold drinks while demand falls during winter;
(ii) Companies that introduce frequently new products, e.g. food canning industry;
(iii) In which production is carried on only after receiving order;
(iv) Companies affected by change of fashion, e.g. millinery trade; and
(v) Where a large part of the output is intended for export, e.g. air conditioning equipment.
Flexible budgetary control has been developed with the objectives of changing the budget figures progressively to correspond with the actual output achieved. Some companies operate flexible budgets in conjunction with a fixed budget.
The preparation of flexible budgets necessitates the analysis of all overheads into fixed, variable and semi-variable costs. This analysis is very much significant in preparing flexible budget because varying levels of output need to be considered and they will have a different effect on each class of overhead.
Significance of Flexible Budgeting:
The following advantages can be derived from flexible budgeting:
(i) It presents a detailed picture of output, costs, sales and profit for varying levels of business operations which makes the marginal analysis more practicable and feasible;
(ii) Flexible budget is an indispensable tool for achieving cost reduction and cost control;
(iii) Flexible budget is useful to forecast for varying level of operations;
(iv) It makes possible the comparison of actual performance and budgeted one for actual level of operation in a very easy and understandable way.
Operational Areas of Flexible Budget:
Preparation of flexible budget is needed in the following cases:
(i) Where the business is subject to the vagaries of nature like agro-based industries, soft drinks, woolen industries etc.
(ii) Where the demand for the product depends upon customers’ tastes and fashion like cotton textile and garment industries.
(iii) Where production is carried out only after receiving the customer’s orders.
(iv) Where business depends heavily on export markets.
(v) Where sales are unpredictable due to typical nature of business and influence of external factors e.g. luxury goods.
(vi) Where customer’s reaction towards a new product is almost impossible to foresee and predict.
The following are the data of ABC Company for the month of June 2003. The Company is working at the capacity of 80%. It produces 8,000 units. The details are as follows: