UNIT-IV Budgets and Budgetary Control

Budgeting is a fundamental aspect of financial management that plays a pivotal role in the

strategic and operational functions of human resource management. As aspiring HR

professionals or fresh entrants in the field, understanding the essence of a budget is vital for

fostering efficient resource allocation and strategic decision-making within an organization.

A budget can be defined as a comprehensive financial plan that outlines anticipated income,

expenses, and resource allocations within a specified timeframe. In the realm of HR, budgets

serve as a structured framework to manage financial resources for HR-related initiatives,

encompassing employee salaries, training programs, recruitment costs, benefits, and other

essential HR functions.

Recognizing the significance of budgeting within HR operations is crucial. It enables the

alignment of HR strategies with the overall organizational goals, ensuring effective utilization of

resources, and facilitating informed decision-making. Integrating budgetary considerations into

HR functions empowers professionals to optimize talent management, foster employee

development and contribute to the company's financial health and success.

Budgetary Control
Budgetary control is a strategic tool that ensures financial stability by monitoring income and

expenditure against planned budgets. It helps organizations optimize resources, reduce wastage,

and improve decision-making by identifying deviations early and implementing corrective

measures to maintain financial discipline and efficiency.

Process of Budgetary Control

After learning what budgetary control is, it is time to learn about the budgetary control process.

Read the steps given below:

1) Comparing Actual Figures Against Budgets:

It is important to analyze your financial data to determine if expenses were higher or lower than

initially planned for your budget. This is done by carefully comparing your original estimated

budget figures to the real expenditure amounts that have occurred to date, which will highlight

any differences and variances between projected and actual costs.

2) Figuring Out Differences:

Variances between budgeted and real spending can be easily calculated using digital tools like

Excel spreadsheets or accounting software programs, which make the necessary computations

easy and efficient.

3) Identifying Current Situation:

To create a useful and realistic budget for the upcoming year, you must first understand where

your company stands financially at present. This involves thoroughly reviewing the precise

amounts that have been spent so far against each item listed on your budget to get an accurate

picture of the utilization of funds till now.

4) Identifying Causes of Differences:

Once over or under-budget areas have been detected, it is important to find the root cause behind

it. Were budgets unrealistic in their projections? Or did employees not follow budget guidelines

as planned? Respectful communication is needed to explain causes and recommend appropriate

solutions.

5) Taking Steps for Effective Controlling:

By closely examining spending habits, we can take focused changes to better align with financial

goals. Customizing actions like adjusting certain allocations, temporarily stopping spending,

revising policies, working closely with department heads in developing future budgets, and

clarifying guidelines for all can spur positive financial changes.

Classification of Budgets

Budgets can be classified in different categories on the basis of time, function and flexibility.

The different budgets covered under each category are shown below :

1. Classification According to Time

The budget, on the basis of time, may be classified as:

Long – term budget

– A budget designed for a long period is defined as long term budget. The period generally is of

5 to 10 years. These budgets are concerned with planning of the operations of a firm over a

considerably long period of time. They are generally prepared in terms of physical quantities.

Short – term budget

– The budget prepared for a period less than 5 years is defined as short term budget. Generally,

short term budget are prepared for a period of one to two years. They are generally prepared in

terms of physical as well as in monetary units.

Current Budget –

The budget prepared for a period of a week, a month or a quarter is termed as a current budget.

They are essentially short term budget adjusted to current conditions or prevailing circumstances.

Rolling Budget:
A rolling budget is continually updated to add a new budget period as the most recent budget

period is completed. Thus, the rolling budget involves the incremental extension of the existing

budget mode

2. Classification According to Function

Different types of budgets under this head are as follows:

Sales Budget:

This is the most important budget on which all other budgets are based. The sales manager is

responsible for preparation and execution of the budget. The budget forecasts total sales in terms

of quantity, value, items, periods, areas etc.

Production Budget:

The budget is basically based on sales budget. It forecasts quantity of production in terms of

items, periods, areas, etc. The work manager is responsible for preparation of overall production

budget and departmental works manager is responsible for departmental production budgets.
Cost of Production Budget:

It forecasts the cost of production. Separate budgets are prepared for different elements of costs

such as direct material budget, direct labour budget, factory overheads budget, office overheads

budget, selling and distribution overhead budget, etc.

Purchase Budget

– The budget forecasts the quantity and the value of purchases required for production. It gives

quantity wise and period wise information about the materials to be purchased. It correlates with

sales forecast and production planning.

Personnel Budget

– The budget anticipates the quantity of personnel required during a period for production

activity. This may be further split up between direct and indirect personnel budgets.

Research Budget
– The budget relates to the research work to be done for improvement in quality of the products

or research for new products.

Capital Expenditure Budget –

The budget provides a guidance regarding the amount of capital that may be required for

procurement of capital assets during the budget period.

Cash Budget –

The budget is a forecast of a cash position, for a specific duration of a time for different time

periods. It states the estimated amount of cash receipts and cash payments and the likely balance

of cash in hand at the end of different periods.

Master Budget –

It is a summary budget incorporating all functional budgets in a capsule form. It interprets

different functional budgets and covers within its range the preparation of projected income

statement and projected balance sheet.

3. Classification According to Flexibility

Budgets can also be classified in the following categories:

Fixed Budget –

A budget prepared on the basis of a standard or fixed level of activity is called a fixed budget. It

does not change with the change in level of activity. If the output and sales do not fluctuate from

year to year or if an accurate prediction of the same can be made, a fixed budget can be prepared.

Flexible Budget –

A budget designed in a manner so as to give the budgeted cost of any level of activity is termed

as flexible budget. Such budget is prepared after considering the fixed and variable elements of

cost and changes that may be expected for each item at various levels of operation

Budgeting Methods
Because budgeting is a process of preparing detailed projects of future amounts, we can create a

budget in many ways, including:

● top-down or bottom-up

● incremental

● zero-based

● rolling

● activity-based.

1. Top-down or bottom-up budgeting

Depending on the people involved, systems available, and the flexibility to plan and propose the

budget, organisations can use a top-down or bottom-up budgeting approach.A top-down budget

is known as an imposed budget. It’s set without any participation by the ultimate budget

holder.A bottom-up budget is known as a participative budget. All budget holders can contribute.

2. Top-down budgeting

Points to consider about imposed/top-bottom budgeting style:

 ● It’s time-efficient because decisions are made by a limited number of senior managers.

● Junior managers might not have the skills to fully participate in the budgeting decision-

making process.

● Senior managers have a better view of strategic objectives and the resources available.

● Senior managers are closer to the strategic objectives and have a long-term view of the

organisation.

● Junior managers could build slack into the budget to make it easier to achieve.

3. Bottom-up budgeting

Points to consider about participative/bottom-up budgeting style:

● Management’s morale is improved.

● Managers are more likely to achieve the plans in the budget.

● Lower-level managers are closer to the business and have better knowledge of unique

issues/challenges and opportunities.

4. Incremental budgeting
Businesses often build on past budgets. The incremental budgeting process starts with the

previous budget and adds (or subtracts) an incremental amount to cover inflation and other

known changes.

Advantages:

● It’s quick and easy to maintain.

● It suits stable organisations with acceptable historic figures.

Disadvantages:

● It embeds earlier issues and inefficiencies.

● Economically inefficient activities can continue.

● It encourages artificial behaviour (i.e. spending the whole budget so the same amount is

included in the following year).

5. Zero-based budgeting

Zero-based budgeting requires all costs to be justified by the expected benefits. It’s an alternative

to incremental budgeting – the budget is based on the previous period’s budget or actual results,

plus extra for inflation and other known changes.

Advantages:

● Inefficient and obsolete operations can be discontinued.

● There’s an increase in staff involvement because it requires a lot more information and

engagement.

● It responds to changes in the business environment.

● There is efficient and effective resource allocation.

Disadvantages:

● It focuses on short-term benefits to the detriment of long-term advantages.

● The rigid budget process leads to lost opportunities.

● Management skills might be lacking.

● Staff might be demotivated by the need for significant time and effort.
6. Rolling budgeting

A rolling budget is continuously updated by adding an accounting period when the earliest

accounting period expires.

Advantages:

● Planning and control are based on an accurate budget.

● It reduces uncertainty.

● The budget extends into the future.

● It encourages managers to reassess the budget regularly and more frequently.

Disadvantages:

● It’s costly and time-consuming.

● Staff might be demotivated by the time spent on budgeting.

● It can lead to less controlled results due to the effort required.

● Version control can be an issue because numbers are always changing.

7. Activity-based budgeting (ABB)

This budget is based on activities. Cost-driver data is used to set budgets and variance analysis.

Advantages:

● This system draws attention to overhead costs, which make up a large proportion

of total operating costs.

● It recognises the activities that drive costs.

● It provides useful information for Total Quality Management (TQM).

Disadvantages:

● It takes time to identify activities.

● It’s difficult to identify responsibility for individual activities.

Variance analysis

Variance analysis is the comparison of predicted and actual outcomes. For example, a company

may predict a set amount of sales for the next year and compare its predicted amount to the

actual amount of sales revenue it receives. Variance measurements might occur monthly,

quarterly or yearly, depending on individual business preferences.

The more frequently a company measures these variances, the more likely it may be to discover

trends in its data. Whether a variance works can depend on the type of variance analysis you

calculate and the predicted variances a company expects.

Businesses may use this type of analysis to calculate variance in the following categories:

● Purchase variance

● Sales variance

● Overhead variance

● Material variance

● Labor variance

● Efficiency variance
Types of variance analysis

The type of variance analysis you perform depends on the information you're examining. Here

are three different types of variance analysis:

1. Material variance

The material variance helps companies identify where they may be using more materials than

they actually need. For example, if a company reorders materials because of quality concerns,

the additional costs may show variance in the analysis.

The company might use this information to determine whether to continue using the same

material supplier or search for a new one. This analytical process can require the use of the

following material formulas to find individual and overall variances:

Quantity variance = (Actual quantity x Standard price) − (Standard quantity x Standard price)

Price variance = (Actual quantity x Standard price) − (Actual quantity x Actual price)
Overall variance = Quantity variance + Price variance

2. Labor variance

The labor variance helps businesses identify how efficiently they use labor and the effectiveness

of their pricing. For example, if a company calculates variance and finds inefficiencies or higher

labor pricing, it might consider making changes for the upcoming fiscal year.

This information may help the company further streamline its operations and save money. Here

are the formulas involved in finding individual and overall variances for labor variance:

Rate variance = (Actual hours x Actual rate) − (Actual hours x Standard rate)

Efficiency variance = (Actual hours x Standard rate) − (Standard hours x Standard rate)

Overall variance = Rate variance + Efficiency variance

3. Fixed overhead variance

The fixed overhead variance helps a company identify differences between its budgeted

overhead costs, which it may determine based on production volumes, and the number of used

overhead costs.For example, if a company wants to revisit its budget plans, it might use fixed

overhead variance to determine whether it can reduce its current allotted budget. This

information may help the company save or allocate money to other areas of the business. Here

are the formulas involved in calculating fixed overhead variance:

Budgeted fixed overhead cost = Denominator level of activity x Standard rate

Budget variance = Actual fixed overhead cost − Budgeted fixed overhead cost

Fixed overhead cost applied to inventory = Standard hours x Standard rate

Volume variance = Budgeted fixed overhead cost − Fixed overhead cost applied to inventory

Overall variance = Budget variance + Volume variance

Capital Budgeting

Capital budgeting is the process of making investment decision in long-term assets or courses of

action. Capital expenditure incurred today is expected to bring its benefits over a period of time.

These expenditures are related to the acquisition & improvement of fixes assets. Capital

budgeting is the planning of expenditure and the benefit, which spread over a number of years. It

is the process of deciding whether or not to invest in a particular project, as the investment

possibilities may not be rewarding. The manager has to choose a project, which gives a rate of

return, which is more than the cost of financing the project. For this the manager has to evaluate

the worth of the projects in-terms of cost and benefits. The benefits are the expected cash inflows

from the project, which are discounted against a standard, generally the cost of capital.

Capital budgeting Techniques:

The capital budgeting appraisal methods are techniques of evaluation of investment proposal will

help the company to decide upon the desirability of an investment proposal depending upon

their; relative income generating capacity and rank them in order of their desirability. These

methods provide the company a set of norms on the basis of which either it has to accept or

reject the investment proposal. The most widely accepted techniques used in estimating the cost-

returns of investment projects can be grouped under two categories.

1. Traditional methods

2. Discounted Cash flow methods

1. Traditional methods

These methods are based on the principles to determine the desirability of an investment project

on the basis of its useful life and expected returns. These methods depend upon the accounting

information available from the books of accounts of the company. These will not take into

account the concept of ‘time value of money’, which is a significant factor to determine the

desirability of a project in terms of present value.

A. Pay-back period method: It is the most popular and widely recognized traditional method of

evaluating the investment proposals. It can be defined, as ‘the number of years required to

recover the original cash out lay invested in a project’.

According to Weston & Brigham, “The pay back period is the number of years it takes the firm

to recover its original investment by net returns before depreciation, but after taxes”.
According to James. C. Vanhorne, “The payback period is the number of years required to

recover initial cash investment.

Payback period = 𝒄𝒄𝒄𝒄 𝒄𝒄𝒄𝒄𝒄𝒄 (𝒄𝒄)𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒄𝒄𝒄𝒄 𝒄𝒄 𝒄𝒄𝒄𝒄𝒄𝒄𝒄 ÷

𝒄𝒄𝒄𝒄𝒄𝒄 𝒄𝒄𝒄𝒄 𝒄𝒄𝒄𝒄𝒄𝒄

Merits:

1. It is one of the earliest methods of evaluating the investment projects.

2. It is simple to understand and to compute.

1. It dose not involve any cost for computation of the payback period

2. It is one of the widely used methods in small scale industry sector

3. It can be computed on the basis of accounting information available from the books.
Demerits

1. This method fails to take into account the cash flows received by the

company after the pay back period.

2. It doesn’t take into account the interest factor involved in an investment

outlay.

3. It doesn’t take into account the interest factor involved in an investment outlay.

4. It is not consistent with the objective of maximizing the market value of the company’s share.

5. It fails to consider the pattern of cash inflows i. e., the magnitude and timing of cash in flows.

B. Accounting (or) Average rate of return method (ARR):It is an accounting method, which uses

the accounting information repeated by the financial statements to measure the probability of an
investment proposal. It can be determine by dividing the average income after taxes by the

average investment i.e., the average book value after depreciation.According to ‘Soloman’,

accounting rate of return on an investment can be calculated as the ratio of accounting net

income to the initial investment, i.e.,

ARR= 𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒄𝒄𝒄 𝒄𝒄𝒄𝒄𝒄𝒄 𝒄𝒄𝒄𝒄𝒄 𝒄𝒄𝒄𝒄𝒄 ÷ 𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄

× 𝒄𝒄𝒄

Average income after taxes= 𝒄𝒄𝒄𝒄𝒄 𝒄𝒄𝒄𝒄𝒄𝒄 𝒄𝒄𝒄𝒄𝒄 𝒄𝒄𝒄𝒄𝒄÷ n𝒄.𝒄𝒄 𝒄𝒄𝒄𝒄𝒄

Average investment =𝒄𝒄𝒄𝒄𝒄 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄÷2

On the basis of this method, the company can select all those projects who’s ARR is higher than

the minimum rate established by the company. It can reject the projects with an ARR lower than

the expected

rate of return. This method can also help the management to rank the proposal on the basis of

ARR. A highest rank will be given to a project with highest ARR, where as a lowest rank to a

project with lowest ARR.

Merits

1. It is very simple to understand and calculate.

2. It can be readily computed with the help of the available accounting data.

3. It uses the entire stream of earning to calculate the ARR.

Demerits:

1. It is not based on cash flows generated by a project.

2. This method does not consider the objective of wealth maximization

3. IT ignores the length of the projects useful life.

4. It does not take into account the fact that the profits can be re-invested.
II: Discounted cash flow methods:

The traditional method does not take into consideration the time value of money. They give

equal weight age to the present and future flow of incomes. The DCF methods are based on the

concept that a rupee earned today is more worth than a rupee earned tomorrow. These methods

take into consideration the profitability and also time value of money.

A. Net present value method (NPV)

The NPV takes into consideration the time value of money. The cash flows of different years and

valued differently and made comparable in terms of present values for this the net cash inflows

of various period are discounted using required rate of return which is predetermined.

According to Ezra Solomon, “It is a present value of future returns, discounted at the required

rate of return minus the present value of the cost of the investment.”

NPV is the difference between the present value of cash inflows of a project and the initial cost

of the project.
According the NPV technique, only one project will be selected whose NPV is positive or above

zero. If a project(s) NPV is less than ‘Zero’. It gives negative NPV hence. It must be rejected. If

there are more than one project with positive NPV’s the project is selected whose NPV is the

highest.

The formula for NPV is

NPV= Present value of cash inflows – investment.

NPV= 𝒄𝒄 ÷ 𝒄+𝒄+𝒄𝒄 ÷ (𝒄+𝒄)+𝒄𝒄 ÷ (𝒄+𝒄)+𝒄𝒄 ÷ (𝒄+𝒄)

Co- investment

C1, C2, C3… Cn= cash inflows in different years.

K= Cost of the Capital (or) Discounting rate

D= Years.
Merits:

1. It recognizes the time value of money.

2. It is based on the entire cash flows generated during the useful life of the asset

3. It is consistent with the objective of maximization of wealth of the owners.

4. The ranking of projects is independent of the discount rate used for determining the present

value.

Demerits:

1. It is different to understand and use.

2. The NPV is calculated by using the cost of capital as a discount rate. But the concept of cost of

capital. If self is difficult to understood and determine.

3. It does not give solutions when the comparable projects are involved in different amounts of

investment.

4. It does not give correct answer to a question whether alternative projects or limited funds are

available with unequal lines.

B. Internal Rate of Return Method (IRR)The IRR for an investment proposal is that discount

rate which equates the present value of cash inflows with the present value of cash out flows of

an investment. The IRR is also known as cutoff or handle rate. It is usually the concern’s cost of

capital.

According to Weston and Brigham “The internal rate is the interest rate that equates the present

value of the expected future receipts to the cost of the investment outlay.

The IRR is not a predetermine rate, rather it is to be trial and error method. It implies that one has

to start with a discounting rate to calculate the present value of cash inflows. If the obtained

present value is higher than the initial cost of the project one has to try with a higher rate. Like

wise if the present value of expected cash inflows obtained is lower than the present value of

cash flow. Lower rate is to be taken up. The process is continued till the net present value

becomes Zero. As this discount rate is determined internally, this method is called internal rate of

return method.
IRR= L+(𝒄𝒄−𝒄 ÷ 𝒄𝒄−𝒄𝒄)× 𝒄

L- Lower discount rate

P1 - Present value of cash inflows at lower rate.

P2 - Present value of cash inflows at higher rate.

Q- Actual investment

D- Difference in Discount rates.

Merits:

1. It consider the time value of money

2. It takes into account the cash flows over the entire useful life of the asset.
3. It has a psychological appear to the user because when the highest rate of return projects are

selected, it satisfies the investors in terms of the rate of return an capital

4. It always suggests accepting to projects with maximum rate of return.

5. It is inconformity with the firm’s objective of maximum owner’s welfare.

Demerits:

1. It is very difficult to understand and use.

2. It involves a very complicated computational work.

3. It may not give unique answer in all situations.

C. Probability Index Method (PI)

The method is also called benefit cost ration. This method is obtained cloth a slight modification

of the NPV method. In case of NPV the present value of cash out flows are profitability index

(PI), the present value of cash inflows are divide by the present value of cash out flows, while

NPV is a absolute measure, the PI is a relative measure.

It the PI is more than one (>1), the proposal is accepted else rejected. If there are more than one

investment proposal with the more than one PI the one with the highest PI will be selected. This

method is more useful incase of projects with different cash outlays cash outlays and hence is

superior to the NPV method.

The formula for PI is

Probability Index = 𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒄𝒄𝒄𝒄𝒄 𝒄𝒄 𝒄𝒄𝒄𝒄𝒄𝒄 𝒄𝒄𝒄𝒄 𝒄𝒄𝒄𝒄𝒄𝒄 ÷

𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄

Merits:

1. It requires less computational work then IRR method

2. It helps to accept / reject investment proposal on the basis of value of the index.

3. It is useful to rank the proposals on the basis of the highest/lowest value of the index.

4. It is useful to tank the proposals on the basis of the highest/lowest value of the index.

5. It takes into consideration the entire stream of cash flows generated during the useful life of

the asset.

Demerits:

1. It is some what difficult to understand

2. Some people may feel no limitation for index number due to several limitation involved in

their competitions

3. It is very difficult to understand the analytical part of the decision on the basis of probability

index.