Budgets and Budgetary Control — Practice

Question 1

Distinguish a budget from budgetary control, and explain why a budget prepared and then never compared against actual results fails to deliver the value the exercise is meant to produce.

Accepted Answer

A budget is a quantitative, financial statement, prepared prior to a defined period, setting out the policy to be pursued during that period to attain a given objective; it is, at its core, a plan expressed in numbers, fixed at a point in time before the period it covers actually begins. Budgetary control is the broader, ongoing process built around that plan: establishing the budget, comparing actual results against it as the period unfolds, and taking corrective action where actual results diverge from what was planned. A budget prepared and then never compared against actual results fails to deliver the value the exercise is meant to produce because the budget on its own is only a forecast, a statement of intent fixed before the fact; its real management value comes from the feedback loop budgetary control provides, surfacing divergences between plan and reality while there is still time to act on them, whether by correcting an operational problem, revising an unrealistic assumption, or reallocating resources. A budget filed away and consulted only in retrospect, if at all, has been reduced to a historical curiosity rather than the active management tool it is designed to be, since none of the corrective, forward-looking action that gives budgetary control its purpose has actually occurred.

Question 2

A company's fixed budget for 8,000 units shows fixed cost of Rs.2,40,000 and variable cost of Rs.35 per unit. Actual production was 9,500 units, and actual total cost incurred was Rs.5,90,000. Compute the flexed budget cost at actual activity, the genuine variance, and explain why comparing actual cost directly against the original fixed budget would be misleading.

Accepted Answer

The flexed budget cost at actual activity is budgeted fixed cost, unchanged in total since fixed cost does not vary with volume, plus budgeted variable cost per unit applied to actual activity: 2,40,000 plus (35 times 9,500), that is 2,40,000 plus 3,32,500, giving 5,72,500. The genuine variance is actual cost less the flexed budget: 5,90,000 less 5,72,500, giving 17,500 Adverse, a comparatively modest and informative figure. Comparing actual cost directly against the original fixed budget, which was prepared for only 8,000 units, at cost of 2,40,000 plus (35 times 8,000), that is 2,40,000 plus 2,80,000, giving 5,20,000, would produce an apparent variance of 5,90,000 less 5,20,000, that is 70,000 Adverse, a far larger and substantially misleading figure. The reason this direct comparison is misleading is that most of that 70,000 apparent gap simply reflects the fact that 1,500 more units were actually produced than the fixed budget planned for, and producing more units genuinely costs more in variable cost terms; none of that volume-driven increase reflects poor cost control or inefficiency, since it was the correct and expected outcome of running the process at a higher activity level. Only after flexing the budget to the actual 9,500 units, so that the comparison is genuinely like-for-like at the same activity level, does the remaining 17,500 adverse variance emerge as the portion of the total gap that actually reflects a real spending or efficiency issue worth investigating.

Question 3

Budgeted sales for the period are 15,000 units. The company wants closing finished goods stock of 3,000 units, against opening finished goods stock of 2,000 units. Each unit requires 4 kg of raw material. The company wants closing raw material stock of 8,000 kg, against opening raw material stock of 6,000 kg. Compute the production budget and the material purchase budget.

Accepted Answer

The production budget is built from the sales budget, adjusted for the planned change in finished goods stock: Production (units) equals Budgeted Sales plus Desired Closing Stock less Opening Stock, that is 15,000 plus 3,000 less 2,000, giving 16,000 units to be produced during the period. The reasoning is that production must cover not only what will be sold but also whatever additional finished goods the company wants to be holding at the end of the period beyond what it already held at the start; since desired closing stock exceeds opening stock by 1,000 units here, production must exceed sales by that same 1,000 units to build up the stock as intended. The material purchase budget is then built from the production budget, converting units of output into the raw material those units require, and again adjusted for the planned change in raw material stock: material required for budgeted production is 16,000 units times 4 kg per unit, giving 64,000 kg. Purchase Budget (kg) equals material required for production plus Desired Closing Stock of raw material less Opening Stock of raw material, that is 64,000 plus 8,000 less 6,000, giving 66,000 kg to be purchased during the period. The same logic applies at this second stage: purchases must cover not only the material actually needed to run the planned production but also the additional 2,000 kg the company wants to be holding in raw material stock at the end of the period beyond what it already held at the start.

Question 4

A company's budgeted profit for a period is Rs.5,00,000, driven substantially by a large credit sale of Rs.4,00,000 to be collected only in the following period. Explain why this period's cash budget could still show a shortfall despite the healthy budgeted profit, and why cash budgeting is treated as a distinct exercise from the profit-focused functional budgets.

Accepted Answer

Budgeted profit is computed on an accrual basis, recognising revenue when it is earned regardless of when the cash for it is actually received, whereas a cash budget tracks only the actual timing of cash receipts and payments. The large credit sale of 4,00,000 is fully included in this period's budgeted profit, since the sale has been made and revenue is recognised in the period it occurs, but no cash from it will actually be received until the following period, meaning this period's cash budget receives none of the benefit of that 4,00,000 despite it driving a substantial share of the healthy reported profit. If the company's cash outflows for this period, wages, supplier payments, overheads and any other commitments, exceed the cash actually collected, which excludes the uncollected credit sale, the cash budget can show a genuine shortfall in this same period that reports strong profit, a combination that surprises managers unfamiliar with the distinction and that has caused real business difficulty for companies that grow revenue quickly on credit terms without managing the resulting cash timing. This is precisely why cash budgeting is treated as a distinct exercise from the profit-focused functional budgets rather than assumed to follow automatically from them: profit and cash genuinely diverge whenever the timing of revenue and expense recognition differs from the timing of the associated cash movements, and a business can be simultaneously profitable on paper and in genuine danger of being unable to pay its bills, which only a separate, explicit cash budget, forecasting receipts and payments period by period, can reveal in advance with enough lead time for financing or collection action to be taken.

Question 5

Explain the role of the master budget relative to the individual functional budgets, and state what two summary statements it typically consolidates into.

Accepted Answer

The master budget is not itself a separate, independently prepared plan but the consolidation of every individual functional budget, sales, production, material purchase, labour, overheads and cash, into one overall, integrated financial picture for the period. Each functional budget covers one specific area of the business in operational detail, useful to the manager responsible for that area, but none on its own tells senior management what the business as a whole is expected to achieve financially; the master budget performs that integration, drawing together the revenue expected from the sales budget, the costs expected from the production, labour and overhead budgets, and the resulting cash position from the cash budget, into a coherent overall statement of the business's budgeted performance and position. It typically consolidates into two summary statements: a budgeted profit and loss account, showing the budgeted revenue, costs and resulting profit for the period drawn from the functional budgets that feed into it, and a budgeted balance sheet, showing the budgeted financial position, assets, liabilities and equity, expected at the end of the period given the planned activities and the cash and stock movements the functional budgets project. Together these give management the complete, top-level financial picture the individual functional budgets, taken in isolation, cannot provide.

Question 6

Explain the difference between incremental budgeting and zero-based budgeting, describe the decision package mechanism ZBB uses, and explain why ZBB is typically applied selectively rather than across an entire organisation's budget.

Accepted Answer

Incremental budgeting starts from last year's actual or budgeted figure and adjusts it, typically upward for inflation, growth, or a known specific change, implicitly assuming that last year's level of spending was broadly justified in the first place and simply needs updating for the new period; the practical consequence is that an item of spending, once established in a budget, tends to be carried forward and grown almost automatically, since removing it requires an active, adversarial decision to cut it out. Zero-based budgeting starts from a base of zero every period, requiring every item of expenditure to be justified afresh, as though it were being proposed for the very first time, rather than assumed to continue merely because it appeared in the prior budget; nothing is grandfathered in purely by precedent. The mechanism ZBB uses is the decision package: each activity or item of expenditure is described in a package setting out what the activity is, what it costs, and the consequence of not funding it at all, and these packages, once prepared across the areas being budgeted, are ranked against each other by priority and funded in that ranked order until the available budget for the period is exhausted, meaning lower-priority packages may simply go unfunded if the budget runs out before reaching them. ZBB is typically applied selectively, most often to discretionary spending areas particularly prone to inefficient, unexamined growth under incremental budgeting, rather than universally across an entire organisation, because building and justifying decision packages from scratch for every single item, every single period, is a substantially heavier and more time-consuming exercise than simply adjusting last year's figures; applying it everywhere would impose a large ongoing administrative burden that, for many routine, clearly necessary and stable areas of spending, would purchase little additional insight relative to the effort required, making selective application the more common practical compromise between ZBB's genuine benefits and its real cost in time and effort.

Question 7

Define fixed budget and flexible budget, and state the situation in which comparing actual results against a fixed budget remains a fair and meaningful comparison without needing to flex it first.

Accepted Answer

A fixed budget is a budget prepared for one specific, single level of activity and not adjusted regardless of the level of activity actually achieved during the period; whatever volume actually occurs, the fixed budget's figures remain exactly as originally set. A flexible budget is prepared to show budgeted cost and revenue at several different levels of activity, built by separating cost into its fixed and variable behaviour so that the budget can be recalculated, or flexed, to whatever activity level is actually relevant for comparison purposes. The situation in which comparing actual results against a fixed budget remains fair without needing to flex it first is where actual activity turns out to equal, or to be acceptably close to, the single activity level the fixed budget was originally prepared for; in that specific case there is no meaningful volume gap between the budgeted and actual activity levels for a volume-driven distortion to arise from, so the fixed budget figures and the actual figures are already being compared on a like-for-like activity basis, and flexing would produce essentially the same comparison the fixed budget already provides. It is only when actual activity diverges materially from the activity level the fixed budget assumed that flexing becomes necessary to produce a genuinely informative variance rather than one contaminated by the volume difference.

Question 8

The production budget calls for 8,000 units. Each unit requires 3 standard labour hours at a standard rate of Rs.70 per hour. The company has 22,000 labour hours available at this rate. Compute the labour budget in hours and cost, and identify any capacity constraint.

Accepted Answer

Labour hours required for the production budget are units to be produced multiplied by standard hours per unit: 8,000 units times 3 hours, giving 24,000 hours required. Labour cost budget is hours required multiplied by the standard rate: 24,000 times 70, giving 16,80,000. Comparing hours required, 24,000, against hours available, 22,000, reveals a capacity constraint: the company does not have enough labour hours available at the standard rate to meet the full production budget as planned, falling short by 24,000 less 22,000, that is 2,000 hours. This shortfall requires management action before the budgets can be finalised as internally consistent: options typically include revising the production budget downward to a level achievable within available capacity, arranging additional labour hours through overtime or additional hiring, likely at a rate above the standard 70 per hour and therefore affecting the labour cost budget upward, or investigating whether efficiency improvements could reduce the standard hours per unit required. This illustrates why functional budgets, though presented in sequence from sales through to labour and overheads, are not each simply computed independently in isolation and accepted regardless of what they reveal; a capacity shortfall surfaced at the labour budget stage must be resolved by revisiting an earlier budget, here potentially the production budget itself, before the full set of functional budgets can be considered a coherent, achievable plan rather than an internally contradictory set of figures.

Question 9

A department's budget for 5,000 units shows fixed cost of Rs.1,50,000, variable material cost of Rs.40 per unit, and variable labour cost of Rs.25 per unit. Actual production was 5,600 units, and actual costs were: fixed Rs.1,55,000, material Rs.2,28,000, labour Rs.1,47,000. Compute the flexed budget for each cost element and the resulting variance for each.

Accepted Answer

Flexed fixed cost remains at the original budgeted total regardless of actual activity, since fixed cost does not vary with volume when flexing: flexed fixed cost is 1,50,000. Flexed variable material cost is the budgeted rate per unit applied to actual activity: 40 times 5,600, giving 2,24,000. Flexed variable labour cost is similarly 25 times 5,600, giving 1,40,000. Comparing actual against flexed for each element: fixed cost variance is actual 1,55,000 less flexed 1,50,000, giving 5,000 Adverse, a genuine spending variance since flexing does not change the fixed cost benchmark regardless of activity. Material cost variance is actual 2,28,000 less flexed 2,24,000, giving 4,000 Adverse, a genuine variance now that the volume effect has been stripped out by flexing to actual production of 5,600 units rather than comparing against the original 5,000-unit budget. Labour cost variance is actual 1,47,000 less flexed 1,40,000, giving 7,000 Adverse. Total genuine variance across all three elements is 5,000 plus 4,000 plus 7,000, giving 16,000 Adverse. Had the comparison instead been made against the original, unflexed budget prepared for only 5,000 units, the apparent variances would have been substantially larger and materially misleading, since a large part of the gap would simply reflect the fact that 600 more units were actually produced than originally budgeted, and that additional, entirely expected variable cost has nothing to do with genuine spending control or efficiency; flexing each cost element separately, respecting each one's own fixed or variable behaviour, is what isolates the smaller, genuinely informative variance actually worth investigating.

Question 10

Production budget is 6,000 units, each requiring 2.5 kg of raw material, but the material handling process causes an expected 4% wastage of material issued to production. Desired closing stock of raw material is 1,000 kg and opening stock is 1,500 kg. Compute the purchase budget in kg, accounting for the wastage.

Accepted Answer

Because 4% of material issued to production is expected to be wasted in handling, the material actually needed to be issued to production must be grossed up beyond the pure 2.5 kg per unit theoretical requirement, since some of what is issued will not end up in good finished units at all. Theoretical material required for good output is 6,000 units times 2.5 kg, giving 15,000 kg. If wastage is 4% of material issued, then good material used represents 96% of material issued, so material to be issued to production is 15,000 divided by 0.96, giving approximately 15,625 kg. This 15,625 kg is the figure that represents material genuinely required for production purposes, inclusive of the expected wastage allowance, and it is this figure, not the simpler 15,000 kg theoretical requirement, that should feed into the purchase budget computation. Purchase Budget in kg is material required for production plus Desired Closing Stock less Opening Stock: 15,625 plus 1,000 less 1,500, giving 15,125 kg to be purchased during the period. Omitting the wastage adjustment and using the simpler 15,000 kg figure instead would understate the purchase budget by approximately 625 kg, precisely the additional material genuinely needed to compensate for the expected 4% loss in handling, and would leave the company short of material relative to what production actually requires once the realistic wastage rate is properly accounted for.

Question 11

A marketing department's budget has grown by roughly 8% every year for the past five years under incremental budgeting, with no individual campaign or activity ever being formally re-justified. Senior management suspects some of this spending may no longer be effective. Recommend an approach, and explain what specifically ZBB would surface that continuing with incremental budgeting would not.

Accepted Answer

Senior management should consider applying zero-based budgeting specifically to this marketing department for the coming budget cycle, rather than continuing with incremental budgeting, precisely because the symptom described, steady growth with no individual item ever being actively re-justified, is exactly the pattern ZBB is designed to interrupt. Under the continuing incremental approach, each year's budget simply takes the prior year's figure, including whatever ineffective or obsolete campaigns and activities it may already contain, and adds a further increment on top, meaning any genuinely wasteful or underperforming spending that entered the budget at some point in the past has never since been required to justify its continued existence, and has instead simply been carried forward and grown alongside everything else, indistinguishable in the budget document from genuinely effective, high-value activities. Applying ZBB would require every individual marketing activity, each campaign, each ongoing programme, each piece of discretionary spending, to be described in its own decision package, setting out what it costs and what would be lost by not funding it, and these packages would then be ranked against each other by their actual contribution to the department's objectives and funded only in that ranked order until the available budget is exhausted. What this specifically surfaces that incremental budgeting does not is the relative priority and continued justification of each individual item, forcing a genuinely comparative, first-principles evaluation of whether, say, an established but tired annual event still deserves funding ahead of a newer, more promising but smaller initiative, a comparison that incremental budgeting's default-continuation structure never actually forces anyone to make explicit.

Question 12

Explain why the sales budget is described as the starting point of the whole budgeting exercise in most businesses, and identify one type of business for which this default might not hold.

Accepted Answer

The sales budget is typically the starting point because in most businesses, particularly those operating in competitive markets, what can actually be sold is the effective limit on the whole operation, and every other functional budget essentially answers the question of what is needed to support that sales plan: production must make enough to meet forecast sales and desired stock levels, material purchase must supply enough for that production, labour and overhead budgets must resource that same production, and cash budgets must track the resulting receipts and payments. Starting anywhere else risks planning production, purchasing and staffing around a volume the market may not actually absorb, building unwanted inventory or unused capacity. One type of business for which this default might not hold is a business operating under a genuine capacity constraint that limits output below what could otherwise be sold, such as a specialist manufacturer with a unique, hard-to-expand production process facing demand that exceeds what it can physically produce; in that situation, the production budget, or more precisely the capacity constraint underlying it, becomes the effective starting point, with the sales budget adjusted downward to reflect only what capacity can actually support rather than the full demand the market might otherwise absorb, reversing the usual sales-first sequence.

Question 13

A department's total overhead budget for 10,000 units is Rs.7,00,000. Analysis shows Rs.4,00,000 is fixed and the remainder is variable. Prepare the overhead budget flexed to actual production of 11,500 units, and explain why simply scaling the whole Rs.7,00,000 figure up in proportion to volume would be wrong.

Accepted Answer

Variable overhead for the original budget is total overhead less the fixed portion: 7,00,000 less 4,00,000, giving 3,00,000, at 10,000 budgeted units, giving a variable overhead rate of 3,00,000 divided by 10,000, that is 30 per unit. Flexing to actual production of 11,500 units: fixed overhead remains unchanged in total at 4,00,000, since fixed cost by definition does not vary with volume; variable overhead scales to actual volume, 30 times 11,500, giving 3,45,000. Total flexed overhead budget is 4,00,000 plus 3,45,000, giving 7,45,000. Simply scaling the whole original 7,00,000 figure up in proportion to the volume increase, that is 7,00,000 times (11,500 divided by 10,000), giving 8,05,000, would be wrong because it incorrectly treats the entire overhead figure, including its fixed component, as though it varied proportionately with volume, which fixed overhead by definition does not; this naive proportional scaling would overstate the correctly flexed budget by 8,05,000 less 7,45,000, that is 60,000, an amount arising entirely from wrongly inflating the fixed cost component that should have stayed constant. This is precisely why the fixed and variable split must be identified and applied separately when flexing any budget, rather than treating the total budgeted figure as a single, undifferentiated amount that simply scales in proportion to activity.

Question 14

For a month, budgeted cash receipts from customers are Rs.6,00,000, and budgeted cash payments are: to suppliers Rs.3,20,000, wages Rs.1,40,000, and a loan instalment of Rs.80,000. Opening cash balance is Rs.50,000. Compute closing cash balance, and explain what a negative closing balance would signal that a budgeted profit figure for the same month would not necessarily reveal.

Accepted Answer

Total budgeted cash payments for the month are 3,20,000 plus 1,40,000 plus 80,000, giving 5,40,000. Net cash movement for the month is receipts less payments: 6,00,000 less 5,40,000, giving a net inflow of 60,000. Closing cash balance is opening balance plus net movement: 50,000 plus 60,000, giving 1,10,000. Had the figures instead produced a negative closing balance, that would signal something a budgeted profit figure for the same month would not necessarily reveal at all: profit is computed on an accrual basis, recognising revenue and expenses when they are earned or incurred rather than when cash actually moves, and a business can report a healthy budgeted profit for a month while simultaneously facing a genuine cash shortfall in that same month, if, for instance, a large share of that period's revenue is on credit terms not yet collected, or if cash payments include items that are not current-period expenses at all, such as the loan instalment here, which includes a capital repayment component that never appears in the profit and loss account as an expense but is nonetheless a genuine, unavoidable cash outflow. A negative closing cash balance specifically signals that the business, whatever its accounting profit, will not have enough cash on hand to meet its payment obligations for the period unless it arranges additional financing, draws on a credit facility, or otherwise secures cash from a source outside its ordinary operating receipts, which is exactly the kind of advance warning a separate, explicit cash budget is designed to surface before the shortfall actually arrives as an operational crisis.

Question 15

A company has prepared sales, production, material purchase, labour, overhead and cash budgets independently, but management wants to know the single, overall budgeted profit figure and the expected year-end financial position before finalising the plan. Explain what step is still missing, and why none of the individual functional budgets alone can answer management's question.

Accepted Answer

The step still missing is preparation of the master budget, which consolidates every one of the individual functional budgets, sales, production, material purchase, labour, overhead and cash, into an overall budgeted profit and loss account and budgeted balance sheet for the period. None of the individual functional budgets alone can answer management's question because each is built for a narrower, operational purpose relevant to the manager responsible for that specific area: the sales budget tells a sales manager what revenue is expected and from which products or regions, the production budget tells a production manager how many units to make and when, the material purchase budget tells a procurement manager how much to buy and in what timing, and so on, but none of these individually assembles the complete picture of how revenue, cost, and the resulting profit and financial position fit together across the whole business. The master budget is specifically the exercise of drawing all of these separate operational plans together into the two summary financial statements management actually needs to evaluate the plan as a whole and to communicate it to stakeholders such as a board or a lender: a budgeted profit and loss account, showing the revenue and costs drawn from the functional budgets and the resulting budgeted profit, and a budgeted balance sheet, showing the budgeted financial position, including cash, stock and other assets and liabilities, that results from the planned activities. Without this consolidation step, the company has a set of separately coherent operational plans but no single, integrated view of what those plans mean for the business's overall financial performance and position, which is exactly the gap the master budget exists to close.

Practice — Budgets and Budgetary Control

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