FLEXIBLE & ZERO BASE BUDGETING:Efficiency Ratio, Performance budgeting

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Cost & Management Accounting (MGT-402)

LESSON# 40

FLEXIBLE & ZERO BASE BUDGETING

The Flexible Budget is designed to change in accordance with the level of activity attained. Thus,

when a budget is prepared in such a manner that the budgeted cost for any level of activity is

available, it is termed as flexible budget. Such a 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 budgeting is desirable in the following cases:

Where, because of the nature of business, sales are unpredictable, e.g. in luxury or semi-luxury

trades.

Where the venture is a new and, therefore, it is difficult to foresee the demand e.g., novelties

and fashion products.

Where business is subject to the vagaries of nature, such as soft drinks,

Where progress depends on adequate supply of labor and the business is in an area which

suffering forms shortage of labor.

Controlling ratios

Budget is a part of the planning process. After the various budgets, including the master budget,

have been prepared, you may like to compare actual performance with the budget performance.

This can be done by using three important ratios as shown on the next page.

Control Ratios

Activity Ratio

Capacity Ratio

Efficiency Ratio

The above ratios are expressed in terms of percentages, if the ratio works out to 100 per cent or

more, the trend is taken as favorable, If the ratio is less than 100 per cent, the indication is taken

as unfavorable. We shall discuss these ratios in some detail.

Activity Ratio:

Activity Ratio 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.

Activity Ratio =

Standard hours for actual production

x 100

Budgeted hours

Capacity Ratio:

This ratio indicates whether and to what extent budgeted hours of activity are actually utilized. It

shows the relationship between the actual number of working hours and the maximum possible

number of working hours in a budget period.

Capacity Ratio =

Actual hours worked

x 100

Budgeted hours

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Cost & Management Accounting (MGT-402)

Efficiency Ratio:

This ratio indicates the degree of efficiency attained in production. It is obtain by expressing the

standard hours equivalent to the work produced as a percentage of the actual hours spent in

producing that work

Efficiency Ratio =

Standard hours for actual production

x 100

Actual hours worked

Activity

Calculate: Efficiency, Activity and Capacity ratios and comment on the results obtained for a

factory which produces two units of a commodity in one standard hour. Actual production during

a particular- year is 34,000 units and the budgeted production for the year is 40,000 units. Actual

hours operated are 16,000 (Some clues have been provided).

Two units are produced in one standard hour. Hence, for actual production of 34,000 units,

standard hours required will be 17,000 (i.e. 34,000/2). For budgeted production of 40,000 units,

budgeted hours will be 20.000

(i.e. 40,000/ 2).

Performance budgeting

As explained in the preceding pages, budgeting is nothing but the technique of expressing, largely

in financial terms, the management's plans for operating and financing the enterprise during

specific periods of time- Any system of budgeting, in order to be successful, must provide for

performance appraisal, as well as follow up measures.

The traditional (also known as line-item or object-account) budget in government enumerates

estimated expenditures by type (and quantity) for a specified period of time, usually one year, the

expenditure is classified by object; the personnel are listed by type of position; the budget is

divided into sections according to organizational units, departments, sections; and the types of

expenditure are listed by category. The primary purpose of traditional budget particularly in

government administration is to ensure financial control and meet the requirements of legal

accountability, that is, to ensure that appropriation. Sanction or allotment limits for different items

are not exceeded- 11 thus emphasize only the financial aspects. The expenditures are not related to

the intended or planned outputs (or achievements). The necessity for finking the expenditures (or

inputs in financial terms) to outputs (in physical terms), facilitating the evaluation of outcomes (or

results of activities) cannot be over emphasized.

Performance budgeting (or programme budgeting) has been designed to correct the shortcomings

of traditional budgeting by emphasizing management considerations/ approaches. Both the

financial and physical aspects are incorporated into the budget- A performance budget presents the

operations of an organization in terms of functions, programmes, activities, and projects.

In performance budgeting, Precise detail of job to be performed or services to be rendered is done.

Secondly, the budget is prepared in terms of functional categories and their sub-division into

programmes, activities, and projects. Thirdly, the budget becomes a comprehensive document.

Since the financial and physical results are interwoven, it facilitates management control.

The main objectives of PB are; (1) to coordinate the physical and financial aspects; (ii) to improve

the budget formulation, review and decision-making at all levels of management; (iii) to facilitate

better appreciation and review by controlling.

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Cost & Management Accounting (MGT-402)

Authorities (legislature, Board of Trustees or Governors, etc.) as the presentation is more

purposeful and intelligible; (iv) to make more effective performance audit possible; and (v) to

measure progress towards long-term objectives which are envisaged in a development plan.

Performance budgeting involves evaluation of the performance of the organisation in the context

of both specific, as well as, overall objectives of the organisation. It presupposes a crystal clear

perception of organizational objectives in general, and short-term business objectives as stipulated

in the budget, in particular by each employee of the organisation, irrespective of his level. It, thus,

provides a definite direction to each employee and also a control mechanism to higher

management.

Performance budgeting requires preparation of periodic performance reports. Such reports

compare budget and actual data, and show variances. Their preparation is greatly facilitated if the

authority and responsibility for the incidence of each cost element is clearly defined within the

firm's organizational structure- In addition, the accounting system should be sufficiently detailed

and coordinated to provide necessary data for reports designed for the particular use of the

individuals or cost centers having primary responsibility for specific cost.

The responsibility for preparing the performance budget of each department lies on the respective

Department Head. Each Department Head will be supplied with a copy of the section of the

master budget appropriate to his sphere. For example, the chief buyer will be supplied with the

copy of the materials purchase budget so that he may arrange for purchase of necessary materials-

Periodic reports from various sections of a department will be received by the departmental head

who will submit a summary report about his department to the budget committee. The report may

be daily, weekly or monthly, depending upon the size of business and the budget period. These

reports will be in the form of comparison of budgeted and actual figures, both periodic and

cumulative. The purpose of preparing these reports is to promptly inform about the deviations in

actual and budgeted activity to the person who has the necessary authority and responsibility to

take necessary action to correct the deviations from the budget,

Zero base budgeting

Earlier we have explained the formulation or different types of budgets. If the approach adopted in

the formulation and preparation of budgets is based on current level of operations or activities,

including current level of expenditure and revenue, such budgeting is known as traditional

budgeting. This type of budgeting process generally assumes that the allocation of financial

resources in the past was correct and will continue to hold good for the future as well. In most

cases, an addition is made to the current figures of costs to allow for expected (or even

unexpected) increases. Consequently, the budget generally takes an upward direction year after

year, in spite of generally declining efficiency. Such a system of budgeting cannot be expected to

promote operational efficiency. It may, on the other hand, create several problems for top

management. Some of these problems are:

Programmes 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 alternate means of accomplishing the

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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 organization.

Managers tend to inflate their budget requests resulting in more demand for funds than their

availability these results in recycling the entire budgeting process.

Thus, the traditional budgeting technique may be quite meaningless in the present context when

management must review or re-evaluate every task with a view to better project which have a

positive cost-benefit analysis or which are capable of meeting the objective of the organization.

The above analysis shows that zero base budgeting is in a way an extension of the method of cost-

benefit analysis to the area of the corporate building.

Advantages of Zero Base Budgeting

Let us summaries the advantages of zero base budgeting:

It provides the organization with a systematic way to evaluate different operations and

programmes undertaken. It enables management to allocate resources according to the priority

of the programmes.

It ensures that each and every programme undertaken by management is really essential for the

organization, 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 it does not help in achieving the goals of the

enterprises.

It helps in identifying areas of wasteful expenditure and, desired, it can also be used for

suggesting alternative courses of action.

It facilitates the introduction and- implement of the system of management by objectives. Thus, it

can be used not only for the objective of traditional budgeting, but also for a variety of other

purposes.

It is contended that zero base budgeting it happens only in the (initial stages when to be identified

and decision packages have to be developed or completed. Once this is done, and the

methodology is "clear, zero base budgeting is likely to take less time than the traditional budgeting.

In any case, till such time the organisation is properly acclimatized to the technique of zero base

budgeting, it may be done in a way that all responsibility centers are covered at least once in three

or four years.

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Cost & Management Accounting (MGT-402)

Zero base budgeting as a concept has become quite popular these days. The technique was first

_used by the U.S. Department of Agriculture in 1962. Texas instruments, a multinational company,

pioneered its use in the private sector. Today a number of major companies such as Zerox, BASF,

International Harvester and Eastern Airlines in the United State are using the system. Some

departments of government of India have recently introduced zero bases budgeting with a view to

make the system of control more effective.

The responsibility for preparing the budget rests on the Budget Controller, who is assisted in his

work by a Budget Committee. The Budget Committee may consist of heads of various

departments, viz., Sales, Production, and Personnel. Purchase, Finance etc. Each head of the

department is made responsible for preparing and executing the budget of his department. In a

business organization, preparation of any budget is preceded by a sales forecast. Production budget

is prepared after considering the forecasts embodied in the sales budget and the available

productive capacity etc. Production budget includes the preparation of various cost budgets

associated with production process. Budgets pertaining to different functions or units are then

combined and coordinated into one Master Budget.

The budgets may be revised from time to time if the changed conditions or new developments so

warrant. A budget may be fixed or flexible. A fixed budget is based on fixed volume of activity. If

actual capacity utilization is likely to vary from period to period, flexible budgets are more

desirable. A flexible budget is thus prepared for changing levels of activity. It considers fixed and

variable costs separately and is therefore more useful to a business where the level of activity

cannot be exactly predicted.

In a system of budgetary control, control ratios may be computed and used in order to compare

the actual performance with the budgeted performance. These ratios are: activity ratio, capacity

ratio and efficiency ratio. In case the ratio is hundred percent or more, it is considered favorable. If

it is less than hundred per cent, it is taken as unfavorable.

The traditional budgeting technique which takes the current level of operations as the basis for

estimating the future level of operations is slowly going out of date. It is being increasingly realized

that the traditional technique has serious shortcomings in view of the constantly changing

conditions of today; the management is expected to review and re-evaluate the tasks in view of the

increasing pressures of environment. The concept of zero base budgeting is being considered as a

suitable alternative to replacing the traditional method. Zero base Budgeting technique suggests

that an organization should not only make decisions about the proposed new programmes, but

should also, from time to time, review the appropriateness of the existing.

The concept of Zero base Budgeting has been accepted for adoption in the departments of the

Central Government, and some State Governments.

Activity

ABC Co. wishes to arrange over draft facilities with its bankers during the period April to June

when it will be manufacturing mostly for stock. Prepare a Cash Budget including the extent of

bank facilities the company will require at the end of each month for the above period from the

following data.

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Cost & Management Accounting (MGT-402)

Sales

Purchases

Wages

Rs.

February

18,000

12,480

1,200

March

19,200

14,400

1,400

April

10,800

24,300

1,100

May

17,400

24,600

1,000

June

12,500

26,800

1,500

a) 40% is cash sale.

b) 50 per cent of credit sales is realized in the month following the sale and the remaining 50

per cent in the second month following. Creditors are paid in the month following (he

month of purchase.

c) Cash at bank on the 1st April (estimated) is Rs. 25, 00.

Activity

Jammu Manufacturing Company Ltd. is to start production on 1st January, 19x3- The prime cost

of a unit is expected to be Rs. 40 out of which Rs. 16 is for materials and Rs. 24 for labour. In

addition, variable expenses per unit are expected to be Rs. 8, and fixed expenses per month Rs,

30,000. Payment for materials is to be made in the month following the purchase. One-third of

sales will be for cash and the rest on credit for settlement in the following month. Expenses are

payable in the month in which they are incurred. The selling price is fixed at Rs. 80 per unit the

number of units manufactured and sold is expected to be as under:

January

900

April

2,000

February

1,200

May

2,100

March

1,800

June

2,400

Draw a cash budget showing requirements of cash from month to month.

Activity

The Sudershan Chemicals Ltd., operates a system of flexible budgetary control.

A flexible budget is required to show levels of activity at 70%, 80% and 90%. The

following is a summary of the relevant information:

Sales based on normal level of activity of 70% (3,50,000) units at

Rs. 200 each. If output is increased to 80% and 90%, selling prices are to be reduced by

2.5% and 5% of the original selling price respectively in Order to reach a wider market.

Variable costs are Rs. 100 per unit (70% is the cost of raw material). In case output

reaches 80% level of activity or above the effective purchase of raw material will be

reduced by 5%.

Variable overheads: Salesman's commission is 2% of sale value.

Semi-variable overheads (total) at 3,50,000 units are Rs. 1,20,00,000. They are expected

to increase by 5% if output reaches a level of activity of 80% and by a further 10% if it

reaches the 90% level,

Total fixed overheads are Rs. 2,00,000, which is likely to remain unchanged up to 100%

capacity.

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Cost & Management Accounting (MGT-402)

Activity

Calculate: (a) Efficiency Ratio (b) Activity Ratio (a) Capacity Ratio from the following figures:

Budgeted production

880 units

Standard hours per unit

Actual production

750 units

Actual working hours

6,000

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