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CHAPTER 5: BUDGETING
Preparation of Budgets: The process of preparing and using budgets will
differ from organisation to organisation. However, there are a number of key
requirements in the design of a budgetary planning and control process.
Co-ordination: Budgets provide a means of co-ordination of the
business as a whole. In the process of establishing budgets, the various
factors like production capacity, sales possibilities, and procurement of
material, labour, etc. are balanced and co-ordinates so that all the activities
proceed according to the objective.
Participative budgeting: CIMA defines participative budgeting as: A
budgeting system in which all budget committee members are given the
opportunity to apply their own budgets in practice.
Budget Manual: A budget manual is a collection of documents that contains
key information for those involved in the planning process.
Identification of the principal budget factor: The principal budget
factor is the factor that limits the activities of functional budgets of the
organization. The early identification of this factor is important in the
budgetary planning process because it indicates which budget should be
prepared first.
There are 4 different types of capacities which are to be kept in view while
preparing budgets:
Maximum capacity = Max. no. of days in a period / No. of workers /
No. of hrs. etc.
Practical capacity = Maximum capacity – Sunday & statutory holidays &
normal maintenance & idle time.
Normal capacity = It is the average of the last 3-years normal
performance if there is any abnormal data, it is not to
be considered in computing the average.
Actual capacity = It can be determined only at the end of the period.
So it has no importance for preparation of budget.
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The capacities can be illustrated as below:
Budget Variance: It is computed on the basis of fixed budgeting system
where budget variance = budgeted cost – actual cost here. The items are
classified first in respective responsibility category & then the
differences are computed individually & totally.
Zero Based Budgeting (ZBB): Zero based budgeting is a decision
oriented approach. In Zero Based budgeting no reference is made to
previous level of expenditure. Zero based budgeting is completely indifferent
to whether total budget is increasing or decreasing. CIMA has defined it “as
a method of budgeting whereby all activities are revaluated each time a
budget is set.”
ZBB is an expenditure control device where each division head has to justify
the requirement of funds for each head of expenditure and prepare the
budget accordingly, without reference to the past budget or achievement.
It is a planning and budgeting process, which requires each manager to
justify his entire requests in detail from „‟scratch‟‟ .(hence zero-base)
Characteristics of ZBB: The Features of ZBB are:
Maximum Or Theoretical Capacity
Operations Interruption (Sundays, Idle
Time, Normal Maint. Etc.)
Idle Capacity (Lack of RM, Machine
Breakdown etc.)
Practical Capacity
Normal Capacity
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1. Manager of a decision unit has to completely justify why there should
be at all any budget allotment for his decision unit. This justification is
to be made a fresh without making reference to previous level of
spending in his department.
2. Activities are identified in decision packages.
3. Decision packages are ranked in order of priority.
4. Packages are evaluated by systematic analysis.
5. Under this approach there exists a frank relationship between superior
and subordinates. Management agrees to fund for a specified service
and manager of the decision unit clearly accepts to deliver the service.
6. Decision packages are linked with corporate objectives, which are
clearly laid down.
7. Available resources are directed towards alternatives in order of
priority to ensure optimum results.
Traditional Budget Vs. ZBB:
Sl.
# Traditional Budget Zero Based Budget
1 Accounting Oriented Responsibility Oriented
2 Past Budgets are used as reference.
At times it will be just inflation of
past budgets
Fresh approach without any previous
reference. Nothing is taken into
account without justification.
3 Routine Approach Investigative approach
4 Not clear and responsive Clear and Responsive
5 Top management decides why
particular amount is to be spent.
User department justifies why the
amount is to be spent and accordingly
approved by the management
Question
Describe the process of zero-base budgeting.
Answer
The zero Base Budgeting involves the following steps:
a. Determine a set of objectives.
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b. Decide about the extent to which the technique of ZBB is to be
applied, Whether in all areas of firm‟s activities or only in a few
selected areas on trial basis.
c. Identify those areas where decisions are required to be taken.
d. Develop decision packages and rank them in order of preferences.
e. Prepare the budget, i.e. translating decision packages into practicable
units/items and allocating financial resources
Question
What are the advantages and limitations of Zero base Budgeting?
Answer
Advantages of ZBB are:
a. Provides a systematic approach for the evaluation of different
activities.
b. Ensures various activities performed by the organisation are
critical for achieving its objectives.
c. Provides an opportunity to the management to allocate resources for
various activities only after having a thorough cost-benefit analysis.
d. Maximum efficiency: Wasteful expenditure is identified and
eliminated.
e. Goal Congruence: Departmental budgets are closely linked with
corporation objectives.
f. Facilitates introducing the system of Management by Objectives.
Limitations of ZBB are:
a. Lack of coordination: Various operational problems are likely to be
faced in implementing. It requires the wholehearted support from Top
Management.
b. It is time consuming as well as costly.
c. It requires proper trained managerial staff.
d. Various operational problems in implementing.
Question
In each of the following independent situations, state with a brief reason
whether 'Zero Base Budgeting' (ZBB) or 'Traditional Budgeting' (TB) would
be more appropriate for year II.
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a. A company producing a certain product has done extensive ZBB
exercise in year I. The activity level is expected to marginally increase
in year Il.
b. The sales manager of a company selling three products has the
intuitive feeling that in year Il, sales will increase for one product and
decrease for the other two. His expectation cannot be substantiated
with figures.
c. The top management would like to delegate responsibility to the
functional managers for their results during year Il.
d. Resources are heavily constrained and allocation for budget
requirements is very strict.
Answer
a. The company has done extensive exercise in year-I that can be used
as a basis for budgeting in year-II by incorporating increase in costs /
revenue at expected activity level. Hence, Traditional Budgeting
would be more appropriate for the company in year-II.
b. In Traditional Budgeting system budgets are prepared on the basis of
previous year‟s budget figures with expected change in activity level
and corresponding adjustment in the cost and prices. But under Zero
Base Budgeting (ZBB) the estimations or projections are converted
into figures. Since, sales manager is unable to substantiate his
expectations into figures so Traditional Budgeting would be
preferred against Zero Base Budgeting.
c. Zero Base Budgeting would be appropriate as ZBB allows top-level
strategic goals to be implemented into the budgeting process by tying
them to specific functional areas of the organization, where costs can
be first grouped, then measured against previous results and current
expectations.
d. Zero Base Budgeting alloates resources based on order of priority up
to the spending cut-off level (maximum level upto which spending can
be made). In an organisation where resources are constrained and
budget is allocated on requirement basis, Zero Base Budgeting is
more appropriate method of budgeting.
Question
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What do you mean by a flexible budget? Give an example of an industry
where this type of budget is typically needed?
Answer
A flexible budget is a budget which, by recognizing the difference between
fixed, semi-variable and variable costs, is designed to change in relation to
the level of activity attained. i.e. the budget is prepared for different levels
of activity. These sort of budgets are used in the following types of
industries.
a. seasonal products – e.g. soft drink industry
b. industries influenced by change in fashion.
c. Industries which keep on introducing new products / new designs.
Question
What are the various formulae used in calculating budget ratios?
Answer
The various formulae that are used for calculating budget ratios are:
a. Efficiency Ratio = (Standard hours ÷ Actual hours) × 100 b. Activity Ratio = (Standard hours ÷ Budgeted hours) × 100 c. Calendar Ratio = (Available working days ÷ budgeted working days) × 100 d. Standard Capacity Usage Ratio = (Budgeted hours ÷ Max. possible hours in the budgeted period) × 100 e. Actual Capacity Usage Ratio = (Actual hours worked ÷ Maximum possible working hours in a period) × 100 f. Actual Usage of Budgeted Capacity Ratio=(Actual working hours ÷ Budgeted hours) × 100
Performance Budgeting (PB): It is the process of analysing, identifying,
simplifying and crystallising specific performance objectives, of a job to be
achieved over a period, within the framework of firm‟s overall objectives,
and within the framework of the purpose and objectives of the job.
Performance Budgeting lays immediate stress on the achievement of
specific goals over a period of time. It aims at a continuous growth of
the firm so that it continues to meet the dynamic needs of its growing
clientele and customers. It requires preparation of periodic performance
reports, which compare budget and actual performance to find out existing
variances.
Traditional budgeting vs. Performance budgeting
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1. The traditional budgeting (TB) gives more emphasis on the financial
aspect than the physical aspects or performance. PB aims at establishing
a relationship between the inputs and the outputs.
2. Traditional budgets are generally prepared with the main basis towards
the objects or items of expenditure i.e. it highlights the items of
expenditure, namely, salaries, stores and materials, rates rents and taxes
and so on. In the PB the emphasis is more on the functions of the
organisation, the programmes to discharge these function and the activities
which will be involved in undertaking these programmes.
Benchmarking
Benchmarking is the process of comparing one's business processes and
performance metrics to industry bests or best practices from other
industries. Dimensions typically measured are quality, time and cost. In the
process of best practice benchmarking, management identifies the best firms
in their industry, or in another industry where similar processes exist, and
compares the results and processes of those studied (the "targets") to one's
own results and processes. In this way, they learn how well the targets
perform and, more importantly, the business processes that explain why
these firms are successful.
Benchmarking is used to measure performance using a specific indicator
(cost per unit of measure, productivity per unit of measure, cycle time of x
per unit of measure or defects per unit of measure) resulting in a metric of
performance that is then compared to others. Benchmarking exercise is
based on best practices rather than best performances.
Benchmarking is also referred to as "best practice benchmarking" or
"process benchmarking"; this process is used in management and
particularly strategic management, in which organizations evaluate various
aspects of their processes in relation to best practice companies' processes,
usually within a peer group defined for the purposes of comparison. This
then allows organizations to develop plans on how to make improvements or
adapt specific best practices, usually with the aim of increasing some aspect
of performance. Benchmarking may be a one-off event, but is often treated
as a continuous process in which organizations continually seek to improve
their practices.
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Question
What are benchmarking code of conduct?
Answer
Benchmarking is the process of identifying and learning from the best
practices, anywhere in the world. It is a powerful tool for continuous
improvement.
To contribute to efficient, effective and ethical benchmarking, individuals
agree for themselves and their organisation to be abided by the following
principles for the benchmarking with other organisations.
a. Principle of legality: If there is likely to be any legal problem, then
such thing should not be done.
b. Principle of exchange: Similar type of information and at similar level
is to be exchanged.
c. Principle of confidentiality: Information should not be passed to other
organisations.
d. Principle of use: Information must be used only for Benchmarking
purposes and not for other purposes.
e. Principle of first party contact: The person who is to be contacted for
exchange of information is to be specified by each organisation.
f. Principle of third party contact: Prior consent of the party is to be
obtained before passing information to another organisation or
person.
g. Principle of preparation: Make the most of your Benchmarking
partners time by being fully prepared for exchange of information.
h. Principle of completion: Complete Benchmarking study to the
satisfaction all Benchmarking partners by fulfilling all mutually agreed
commitments.
i. Principle of understanding: understand how your Benchmarking
would like to be treated.
Question
Explain briefly stages involved in the process of Benchmarking.
Answer
C A & C M A Coaching Centre, Nallakunta, Hyderabad. P V Ram, B. Sc., ACA, ACMA – 98481 85073
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The process of benchmarking requires a Company to identify the areas i.e.
processes, activity etc. which are central to its business and then selects the
top - performing companies in those areas.
1. Planning:
a. Determination of benchmarking goal statement: This requires
identification of areas to be benchmarked. In practice, one should
start with the identification of those areas which have to be really
good to be really successful.
b. Identification of best performance: Once the benchmarked goal
statement are defined, the step is seeking the best of the breed of
best of the best.
c. Establishment of the benchmarking or process improvement team:
Ideally this should include the persons who are most knowledgeable
about the internal operations and will be directly affected by
changes due to benchmarking.
d. Defining the relevant benchmarking measurement: Relevant
measures will not include the measures used by the organisation
today but they will be refined measures that comprehend the true
performance differences.
2. Collection of data and information: The data gathering for
benchmarking could be done through national/international clearing
houses, mail surveys, suppliers, company visits, telephone, interviews
etc. In recent years national and international clearing houses have
been set up.
3. Analysing the findings: The analysing of findings of step (2) requires
following:
a. Review the findings and produce tables, charts and graphs to
support the analysts.
b. Identify gaps in performance between our organisation and better
performers.
c. Seek explanations for the gaps in performance. The performance
gaps can be positive, negative or zero.
d. Ensure that comparisons are meaningful and credible.
e. Communicate the findings to those who are affected.
f. Identify realistic opportunities for improvements.
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4. Recommendations: This involves making recommendations
requiring:
a. Deciding the feasibility of making the improvements in the light of
the conditions that apply within own organisation.
b. Agreement of the improvements that are likely to be feasible.
c. Producing a report on the Benchmarking in which the
recommendations are included.
d. Obtaining the support of key stakeholder groups for making the
changes needed.
e. Developing action plan(s) for implementation.
5. Monitoring and reviewing: This involves:
a. Evaluating the benchmarking process undertaken and the results of
the improvements against objectives and success criteria plus
overall efficiency and effectiveness.
b. Documenting the lessons learnt and make them available to others.
c. Periodically re-considering the benchmarks
Question
Describe the four types of benchmarking of critical success factors.
Answer
Benchmarking is primarily classified into internal (comparing performance
between different groups or teams within an organization) or external
(comparing performance with companies in a specific industry or across
industries). This is further classified into:
Within the above broad categories, the Benchmarking is of following types:
a. Product benchmarking (Reverse Engineering. This is called so
because basing on the best available product (bench mark product);
alternative one is developed with similar features.) - The process of
designing new products or upgrades to current ones based on bench
marked product.
b. Process benchmarking: It involves the comparison of an
organisation critical business processes and operations against best
practice organization that performs similar work or deliver similar
services.
c. Competitive benchmarking: It involves the comparison of
competitors products, processes and business results with own.
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d. Strategic benchmarking: It is similar to the process benchmarking
in nature but differs in its scope and depth. This involves observing
how others compete. This type is usually not industry specific,
meaning it is best to look at other industries.
e. Global benchmarking: It is a benchmarking through which
distinction in international culture, business processes and trade
practices across companies are bridged and their ramification for
business process improvement are understood and utilized.
f. Functional Benchmarking or Generic Benchmarking: This type of
benchmarking is used when organisations look to benchmark with
partners drawn from different business sectors or areas of activity to
find ways of improving similar functions or work processes.
g. Internal Benchmarking: It involves seeking partners from within the
same organization, for example, from business units located in
different areas.
h. External Benchmarking: It involves seeking help of outside
organisations that are known to be best in class. External
benchmarking provides opportunities of learning from those who are at
the leading edge, although it must be remembered that not every best
practice solution can be transferred to others.
i. Financial benchmarking - performing a financial analysis and
comparing the results in an effort to assess your overall
competitiveness and productivity. E.g. Comparing ROIs‟, Capital
invested etc.
j. Performance benchmarking - allows the initiator firm to assess
their competitive position by comparing products and services with
those of target firms.
k. Energy benchmarking - process of collecting, analysing and relating
energy performance data of comparable activities with the purpose of
evaluating and comparing performance between or within entities.[7]
Entities can include processes, buildings or companies. Benchmarking
may be internal between entities within a single organization, or -
subject to confidentiality restrictions - external between competing
entities.
Question
Explain the difficulties in Benchmarking.
Answer
The difficulties in implementing Benchmarking are:
a. Time consuming: Benchmarking is time consuming and at times
difficult. It has significant requirement of staff time and Company
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resources. Companies may waste time in benchmarking non-critical
functions.
b. Lack of management Support: Benchmarking implementation
requires the direct involvement of all managers. The drive to be best in
the industry or world cannot be delegated.
c. Resistance from employees: It is likely that their maybe resistance
from employees.
d. Paper Goals: Companies can become pre-occupied with the
measures. The goal becomes not to improve process, but to match the
best practices at any cost.
e. Copy-paste attitude: The key element in benchmarking is the
adaptation of a best practice to tailor it to a company‟s need and
culture. Without that step, a company merely adopts another
Company‟s process. This approach condemns benchmarking to fail
leading to a failure of benchmarking goals.
Costs
The three main types of costs in benchmarking are:
Visit Costs - This includes hotel rooms, travel costs, meals, a token
gift, and lost labour time.
Time Costs - Members of the benchmarking team will be investing
time in researching problems, finding exceptional companies to study,
visits, and implementation. This will take them away from their regular
tasks for part of each day so additional staff might be required.
Benchmarking Database Costs - Organizations that institutionalize
benchmarking into their daily procedures find it is useful to create and
maintain a database of best practices and the companies associated
with each best practice now.
The cost of benchmarking can substantially be reduced through utilizing the
many internet resources that have sprung up over the last few years. These
aim to capture benchmarks and best practices from organizations, business
sectors and countries to make the benchmarking process much quicker and
cheaper.