BBA: II SEMESTER

BBA-22- 201: Cost and Management

Accounting
Dr. SANTOSH KUMAR
ASSISTANT PROFESSOR
School of Management Sciences,
Varanasi
 Unit IV
Management Accounting
Meaning: Management accounting can be viewed as Management-oriented Accounting. It
refers how the accounting function can be re-oriented so as to fit it within the framework of
management activity. The primary task of management accounting is to redesign the entire
accounting system so that it may serve the operational needs of the firm. It is the study of
managerial aspect of financial accounting, "accounting in relation to management function". It
is the accounting for effective management. The financial data are so devised and
systematically development that they become a unique tool for management decision.

Management Accounting which is also known as Accounting for Managers is a process of

collecting information (both qualitative and quantitative) from various sources such as Financial
Accounting, Cost Accounting, Tax Accounting, Human Resource Accounting, etc. selecting the
important ones out of the total, analyzing them with the help of certain tools or techniques and
then pass on to the management for taking decisions in the interest of the organization and the
parties interested into it. Therefore, it can be said that the Management Accounting is selective
in nature where only important information is supplied to the management which have been
collected from different sources. The management takes both routine and strategical decisions
with the help of the information. Actually the Management Accounting works two ways – one
the management is capable of knowing each and every thing about its organization, finds out
the strong and weak points and accordingly takes decisions for grabbing the opportunities
available to the organization in the external environment by facing the challenges and on the
other hand the performance of the management can also be evaluated by various stakeholders
during a particular time period by going through the financial statements of the organization.

In other words, Management accounting collects and provides accounting, cost accounting,
economic and statistical information to the men at various managerial levels to assist them in
the performance of managerial functions and their evaluations. It is closely related with the
development and application of various techniques of recording, analysis, interpretation and
presentation, making the financial, costing, and other data in the performance of managerial
functions, viz., planning, decision-making and control. It should be noted that management
accounting makes use of not only accounting techniques but also of statistical and mathematical
techniques.

As per American Accounting Association (AAA): “Management Accounting includes the

methods and concepts necessary for effective planning, for choosing among alternatives
business actions and for control through the evaluation and interpretation of performances.’

According to the Chartered Institute of Management Accountants (CIMA), Management

Accounting is "the process of identification, measurement, accumulation, analysis, preparation,
interpretation and communication of information used by management to plan, evaluate and
control within an entity and to assure appropriate use of and accountability for its resources.
Management accounting also comprises the preparation of financial reports for non-
management groups such as shareholders, creditors, regulatory agencies and tax
authorities"(CIMA Official Terminology).

Nature of Management Accounting:

We can consider certain aspects as the nature of management accounting:

1. Management accounting is a decision making system: Management accounting

provides accounting information in such a way as to assist management in the creation
of policy and in the day-to-day operations. Though management accountant is not taking
any decision but provides data which is helpful to management in decision making. It
communicates a great variety of facts in a systematic and meaningful manner.
2. Information Supplier: Management accounting caters cost and financial data
information to all levels of management of organization as per their requirements. It
supports to the organization to take fair decisions to achieve its targets. Moreover, the
information provided also helps to review and to compare targets as per planning. It also
serves information for day-to-day operations of the undertaking.
It is the act of making sense of financial and costing data and translating that data into
fruitful information for management of an organization. It provides detailed analytical
data of specific activity or product or division to facilitate better planning and control
functions. Managerial accounting analyzed and used by business leaders to take
decisions and run the company more effectively. Managerial accountants handle many
facets of accounting as per their competence.
3. Forward Looking: Basically by the nature, management accounting is forward looking
and proactive. It supplies information for present and provide information for future
needs of management. Management of organization perceives challenges ahead in the
way. At this point of time Management accounting serves as a forecaster. It provides
information to management not for planning but also for future decision-making.
4. No fixed norms: In management accounting, no set of rules or standards are to be
rightly followed like financial accounting. The required information is provided by
accountant in a manner as it suits the management of organization. Thus, the format and
method of presentation of information is subjective. It is differently reflected in
company’s internal reports.
5. Emphasis on Cause and Effect Analysis: Management accounting studied and
analyzed the cause and effect of results unlike financial accounting and cost accounting.
Financial accounting represents financial results of the particular period. For example,
Profit and Loss Account does not reflect reasons of profit or loss during particular
period. The cause and effect of the profit or loss incurred are probed and the factors
directly influencing the profitability are also studied.
6. Increases Efficiency: The purpose of using accounting information is to increase
efficiency of the concern. It acts as vehicle for enhancing the working efficiency of the
organization. Management accounting uses the accounting information in formatting
plans and setting up objectives. Comparing actual performance with targeted figures
will give an idea to the management about the performance of various departments and
cost centers. When there are deviations, corrective measures can be taken at once with
 the help of techniques such as budgetary control and standard costing for improvements.
The process of fixing the targets and achieving the targets leads to improvement in
efficiency.
7. Assists in Achieving Objectives: Management Accounting is always assist
organization in achieving its predetermined goals. It furnishes information quickly and
at comparatively shorter intervals as per the requirement of the management. It supports
the management of organization through providing the relevant and accurate
information at the right time for taking rational decisions to sort out the business
uncertainties. It also provides detailed information regarding the weaknesses and the
strengths of organization in the form of reports, on the basis of that any organization can
work on to eliminates its business problems and may achieve its goal easily.
8. Techniques and concepts: Management accounting employs special techniques such as
Standard Costing, Marginal costing, Budgeting Control, Project Appraisal etc. to make
accounting data for more fruitful to the management. Each of these techniques serves as
useful tool for specific purposes in analysis and interpretation of data, establishing
control over operations.
9. Internal Use Orientation: The information provided by management accounting is
purely designed and meant for internal use. It provides relevant financial and non-
financial information. Management accountant analyses and interprets the accounting
data to suit the informational needs of the management. Thus, Management accounting
has an internal Orientation.
10. Selective: Management accounting is selective as it focuses only on specific
information which is relevant for decision making. Only relevant facts and information
are taken into account and others are ignored while taking decisions.

Objectives of Management Accounting:

• To Formulate Planning and Policy

1.

• Decision Making
2.

• Analysis and Interpretation of Financial Statements:

3.

• Efficient Co-ordination
4.

• To Provide Reports
5.

• To help in Control
6.
Functions of Management Accounting:
The basic function of management accounting is to assist the management in performing its
functions effectively. The functions of the management are planning, organizing, directing and
controlling. Management accounting helps in the performance of each of these functions in the
various ways:

1) Providing data: Management accounting serves as a vital source of data for

management planning. The accounts and documents are a repository of a vast quantity
of data about the past progress of the enterprise, which are a must for making forecasts
for the future.
2) Modifying data: The accounting data required for managerial decisions is properly
compiled and classified. For example, purchase figures for different months may be
classified to know total purchases made during each period product-wise, supplier-wise
and territory-wise.
3) Analyses and interprets data: The accounting data is analyzed meaningfully for
effective planning and decision making. For this purpose, the data is presented in a
comparative form. Ratios are calculated and likely trends are projected.
4) Serves as a means of communicating: Management accounting provides a means of
communicating management plans upward, downward and outward through the
organization. Initially, it means identifying the feasibility and consistency of the various
segments of the plan. At later stages it keeps all parties informed about the plans that
have been agreed upon and their roles in these plans.
5) Facilitates control: Management accounting helps in translating given objectives and
strategy into specified goals for attainment by a specified time and secures effective
accomplishment of these goals in an efficient manner. All this is made possible through
budgetary control and standard costing which is an integral part of management
accounting.
6) Uses also qualitative information: Management accounting does not restrict itself to
financial data for helping the management in decision making but also uses such
information which may not be capable of being measured in monetary terms. Such
information may be collected form special surveys, statistical compilations, engineering
records, etc.

Scope of Management Accounting:

Management Accounting provides accounting information to the top level management to
facilitate better decision making. The scope of management accounting is very broad based
and covers all the areas. You can see the Systems and techniques fall within the ambit of
management accounting in the figure.
 Financial

Internal Audit Accounting

Cost

Accounting

Management Budgetary
Scope of Management
Reporting Control
Accounting

Inventory Statistical &

QuantitiveTechniques
Control

Tax

Accounting

1) Financial accounting: Financial accounting includes the recording and summarising of

business transactions such as income, expenses, inventory movement, assets, liabilities,
cash receipts, payments etc. and the preparation of financial statements regularly at the
end of each accounting year for knowing operating results for a definite period. The
financial statements include profit and loss account and balance sheet. Management
Accounting analyses and interprets the financial statements to report to top level
management for future projections. Thus financial accounting serves as basis for
management accounting.

2) Cost Accounting: Cost accounting is concerned with the ascertainment of various

elements of costs such as material, labour and overheads of different products, processes
and jobs for business operations. It also serves efficiency of different departments,
divisions and products. With the help of various techniques like standard costing,
marginal costing, absorption costing etc., it helps in knowing the deviations in the
costs. Marginal costing is the most important tool in decision-making. Management
accounting makes use of cost information in taking managerial decisions.

3) Budgetary Control: Budgets are blueprints for future activity to be planned today.
 Budgeting means expressing the plans, policies and goals of the enterprise for a
definite period in future. Different types of budget systems, like production, sales,
materials, labour etc. do exist in organizations. The targets are set for different
departments and responsibility is fixed for achieving these targets. The comparison of
actual performance with budgeted figures will give an idea to the management about
the performance of different departments. If differences remain vast then corrective
measures are taken for prevention in future. Budgetary control is the system of
controlling the cost with the help of budgets. This helps management accounting in
future forecasting.

4) Statistical and Quantitative Techniques: Management accounting makes use of

various statistical methods to provide relevant information to management in the most
reliable and lucid manner. Statistical methods like sampling techniques, probability,
linear programming, and regression analysis are used by management accountant to
make the information more accurate and impressive. Thus, statistical and quantitative
techniques are essential part of management accounting.

5) Tax Accounting: Tax accounting includes the computation of corporate income tax in
accordance with the tax laws, filing of returns and making tax payments. Tax
accounting is an important aspect of management accounting. Tax accounting comes
under the purview of management accountant’s duties and tax planning has become an
integral part of management in the present scenario.

6) Inventory Control: Inventory control refers to exercising control over the utilization
of raw materials, processing of work in progress and disposal of finished goods for a
specific period. It is the system devised and adopted for controlling investment in
inventory. The management should determine different levels of stocks, i.e. minimum
level, maximum level, re- ordering level for inventory control. The control of inventory
will help in controlling costs of products. Management accountant will guide
management as to when and from where to purchase and how much to purchase. So
the study of effective inventory control will be helpful for taking managerial decisions.

7) Management Reporting: Corporate Reporting is divided into two types interim

reporting and external reporting. Interim reporting is supplying information to the top
management. External reporting is supplying information to outsiders i.e. shareholders,
banks and financial institutions. Management reporting refers preparation of monthly,
quarterly, half- yearly reports providing information on the financial, costing and other
aspects of business and updating internal management about real time financial
changes in the organization.

8) Internal Audit: Internal audit is conducted by the business organization through

professionals who have thorough accounting knowledge. It helps the management in
fixing individual responsibility for internal control. All the relevant records are
maintained under the management accounting system so that the internal audit is
conducted in an effective manner.
Limitations of Management Accounting: Through management accounting is helpful
in providing guidelines for planning, directing and controlling functions, still effectiveness is
limited by a number of reasons.
Limitations of management accounting are explained as follows:
1. Based on Accounting Information: Management accounting is based on data supplied
by financial and cost accounting. Historical data is used to make future decisions. The
correctness and effectiveness of managerial decisions will depend upon the quality of
data on which these decisions are based. If financial data is not reliable then
management accounting will not provide correct analysis. Because management
accounting has to depend upon the information collected by other sources, its
effectiveness is limited to the reliability of those sources.
2. Lack of Knowledge: The use of management accounting requires the knowledge of a
number of related subjects. Management should be conversant with accounting
principles, statistics, economics, principles of management, etc., and only then
management accounting can be effectively utilised. Deficiency in knowledge of any of
these subjects limits the use of management accounting. So, the application of
management accounting will be useful if persons connected with decision—making
process have proper understanding not only of management accounting but also of
related subjects.
3. Intuitive Decisions: Though management accounting provides scientific analysis of
various situations and enables decision taking based on facts and figures, there is a
tendency to make decisions intuitively. Management may avoid a lengthy course of
deciding things and may take an easy course of arriving at decisions using intuition.
Intuitive decisions limit the usefulness of management accounting.
4. Not an Alternative to Administration: Management accounting does not provide an
alternative to administration. The tools and techniques of management accounting
provide only information and not decisions. Decisions are to be taken by the
management and their implementation is also done by management. So, management
accounting has supplementary service function and has no final say either in taking
decisions or in their implementation.
5. Top Heavy Structure: The installation of a management accounting system needs an
elaborate organisational system. A large number of rules and regulations are also
required to make this system workable and effective. Introduction of management
accounting system is a costly affair and can be used by big concerns only. Smaller units
cannot afford to use this system because of heavy cost.
6. Evolutionary Stage: Management accounting is only in a developmental stage; it has
not yet reached a final stage. The techniques and tools used by this system give varying
and differing results. The conclusions taken from analysis and interpretation are not the
same. It will take some time before management accounting takes a final shape.
7. Personal Bias: The interpretation of financial information depends upon the capability
of interpreter as one has to make a personal judgement. There is every likelihood of
personal bias in analysis and interpretation. Personal prejudices' and bias affect the
objectivity of decisions.
 8. Psychological Resistance: The installation of management accounting involves basic
change in organisational set up. New rules and regulations are also required to be
framed which affect a number of personnel and hence there is a possibility of resistance
from some quarters or the other.

Budgeting

Concept of Budget and Budgeting:

Budget: A budget is a blue print of a plan expressed in quantitative terms. It is the
monetary or /and quantitative expression of business plans and policies to be pursued in
the future period of time. A budget is an instrument of management used as an aid in the
planning, programming and control of business activity.

The Chartered Institute of Management Accountants (CIMA) UK defines budget as “A

financial and/or quantitative statement, prepared and approved prior to a defined
period of timeof the policy to be pursued during that period for the purpose of attaining
a given objective. It may include income, expenditure and employment of capital” The
budget is a blue- print of the projected plan of action expressed in quantitative terms for
a specified period of time.

Budgeting: Budgeting is technique for formulating budgets. It is the process of

designing, implementing and operating of budget. The main emphasis in budgeting
process is the provision of resources to support plans which are being implemented. It is
a means of coordinating the combined intelligence of an entire organisation into a plan
of action based on past performance and governed by rational judgment of factors that
will influence the course of business in the future.

Characteristics of Good Budgeting

1. A good budgeting system should involve persons at different levels while preparing the
budgets. The subordinates should not feel any imposition on them.
2. There should be a proper fixation of authority and responsibility. The delegation of
authority should be done in a proper way.
3. The targets of the budgets should be realistic, if the targets are difficult to be achieved
then they will not enthuse the persons concerned.
4. A good system of accounting is also essential to make the budgeting successful.
5. The budgeting system should have a whole-hearted support of the top management.
6. The employees should be imparted budgeting education. There should be meetings and
discussions and the targets should be explained to the 'employees concerned.
 Budgetary Control: Budgetary Control is a method of managing costs through preparation
of budgets. Budgeting is thus only a part of the budgetary control. According to CIMA,
“Budgetary control is the establishment of budgets relating to the responsibilities of
executives of a policy and the continuous comparison of the actual with the budgeted results,
either to secure by individual action, the objective of the policy or to provide a basis for its
revision.”
The main features of budgetary control are:
1. Establishment of budgets for each purpose of the business.
2. Revision of budget in view of changes in conditions.
3. Comparison of actual performances with the budget on a continuous basis.
4. Taking suitable remedial action, wherever necessary.
5. Analysis of variations of actual performance from that of the budgeted performance to
know the reasons thereof.

Functions or Purpose or Objectives of Budgeting:

1. Main purpose of Budgeting is to provide the yardstick against which future results can
be compared.
2. To take corrective measures if negative variances are found while comparing actual
results with budgeted results.
3. To ensure the availability of funds at a reasonable cost for capital expenditure.
4. Ensure Co-ordination of different departments to achieve desired goals.
5. To accelerate the efficiency of operations of different departments, divisions and cost
centers of the firm.
6. Insuring desired revenues and exercise control over expenditure so that maximum
profitability can be achieved.
7. Use resources in capital expenditure in the most profitable direction.

Classification and Types of Budgets:

The budgets are usually classified according to their nature. The following are the types of
budgets which are commonly used.
(A) Classification According to Time
1. Long-term budgets. 2. Short-term budgets.
3. Current budgets.
(B) Classification on the Basis of Functions
1. Operating Budgets
2. Financial Budgets
3. Master Budget
(C) Classification on the Basis of Flexibility
1. Fixed budget.
2. Flexible budget
(A) Classification According to Time
 1. Long Term Budgets: The budgets are prepared to depict long term planning of the
business. The period of long-term budgets varies between five to ten years. The long
term planning is done by the top level management; it is not generally known to lower
levels of management. Long time budgets are prepared for some sectors of the
concern such as capital expenditure, research and development, long term finances,
etc. These budgets are useful for those industries where gestation period is long
i.e., machinery, electricity, engineering, etc.
2. Short-term Budgets: These budgets are generally for one or two years and are in
the form of monetary terms. The consumers goods industries like sugar, cotton,
textile, etc. use short term budgets.
3. Current Budgets: The period of current budgets is generally of months and weeks.
These budgets relate to the current activities of the business. According to I.C.W.A.
London, "Current budget is a budget which is established for use over a short period
of time and is related to current conditions."

(B) Classification on the Basis of Functions

1. Operating Budgets: These budgets relate to the different activities or operations of a

firm. The number of such budgets depends upon the size and nature of business.
The commonly used operating budgets are :
(a) Sales Budget
(b) Production Budget
(c) Production Cost Budget
(d)Purchase Budget
(e)Raw Material Budget
(f)Labour Budget
(g)Plant Utilisation Budget
(h)Manufacturing Expenses or Works Overhead Budget
(i)Administrative and Selling Expenses, Budget, etc.
The operating budget for a firm may be constructed in terms of programmes or
responsibility areas, and hence may consist of :
(i) Programme Budget, and (ii) Responsibility Budget.
i. Programme Budget: It consists of expected revenues and costs of various
products or projects that are termed as the major programmes of the firm.
Such a budget can be prepared for each product line or project showing
revenues, costs and the relative profitability of the various programmes.
Programme budgets are, thus, useful in locating areas where efforts may be
required to reduce costs and increase revenues. They are also useful in
determining imbalances and inadequacies in programmes so that corrective
action may be taken in future.
ii. Responsibility Budget: When the operating budget of a firm is
constructed in terms of responsibility areas it is called the responsibility
budget. Such a budget shows the plan in terms of persons responsible for
 achieving them. It is used by the management as a control device to
evaluate the performance of executives who are in charge of various cost
centres. Their performance is compared to the targets (budgets), set for
them and proper action is taken for adverse results, if any. The kinds of
responsibility areas depend upon the size and nature of business activities
and the organisational structure.
However, responsibility areas may be classified under three broad categories:
(a) Cost/ Expense Centre
(b) Profit Centre
(c) Investment Centre.

2. Financial Budgets: Financial budgets are concerned with cash receipts and
disbursements, working capital, capital expenditure, financial position and results of
business operations.
The commonly used financial budgets are :
(d) Cash Budget
(e) Working Capital Budget
(f) Capital Expenditure Budget
(g) Income Statement Budget
(h) Statement of Retained Earnings Budget
(i) Budgeted Balance Sheet or Position
Statement Budget.
3. Master Budget: Various functional budgets are integrated into master budget. This
budget is prepared by the ultimate integration of separate functional budgets. According
to I.C.W.A. London, "The Master Budget is the summary budget incorporating its
functional budgets". Master budget is prepared by the budget officer and it remains with
the top-level management. This budget is used to co-ordinate the activities of various
functional departments and also to help as a control device.

(C) Classification on the Basis of Flexibility

1. Fixed Budget: The fixed budgets are prepared for a given level of activity; the budget
is prepared before the beginning of the financial year. If the financial year starts in
January then the budget will be prepared a month or two earlier, i.e., November or
December. The changes in expenditure arising out of the anticipated changes will not
be adjusted in the budget. There is a difference of about twelve months in the
budgeted and actual figures. According to I.C.W.A. London, "Fixed budget is a
budget which is designed to remain unchanged irrespective of the level of activity
 actually attained." Fixed budgets are suitable under static conditions. If sales, expenses
and costs can be forecasted with greater accuracy then this budget can be
advantageously used.
This budget is not useful because:
 The conditions go on the changing and cannot be expected to be firm.
 The management will not be in a position to assess, the performance of
different heads on the basis of budgets prepared by them because to the
budgeted level of activity.
 It is hardly of any use as a mechanism of budgetary control because it does not
make any difference between fixed, semi‐variable and variable costs
 It does not provide any space for alteration in the budgeted figures as a result
of change in cost due to change in the level of activity
2. Flexible Budgets: A flexible budget consists of a series of budgets for different level
of activity. It, therefore, varies with the level of activity attained. A flexible budget is
prepared after taking into consideration unforeseen changes in the conditions of the
business flexible budget is defined as a budget which by recognising the difference
between fixed' semi-fixed and variable cost is designed to change in relation to the
level of activity.
The flexible budgets will be useful where level of activity changes from time to time.
When the forecasting of demand is uncertain and the undertaking operates under
conditions of shortage of materials, labour etc., then this budget will be more suited.

Flexible budget may prove more useful in the following conditions:

 Where the level of activity varies from period to period.
 Where the business is new and as such it is difficult to forecast the demand.
 Where the organization is suffering from the shortage of any factor of
production. For example, material, labour, etc. as the level of activity depends
upon the availability of such a factor.
 Where the nature of business is such that sales go on changing.
 Where the changes in fashion or trend affects the production and sales.
 Where the organization introduces the new products or changes the patterns
and designs of its products frequently.
 Where a large part of output is intended for the export.
Difference Between a Fixed and Flexible Budget

Basis For
Fixed Budget Flexible Budget
Comparison

Meaning The budget designed to remain constant, The budget designed to change
regardless of the activity level reached is with the change in the activity
Fixed Budget. levels is Flexible Budget.

Nature Static Dynamic

Activity Level Only one Multiple

Performance Comparison between actual and budgeted It provides a good base for making
Evaluation levels cannot be done accurately, if there is a a comparison between the actual
distinction in their activity levels. and budgeted levels.

Rigidity Fixed Budget cannot be modified as per the Flexible budget can be easily
actual volume. modified in accordance with the
activity level attained.

Estimates Based on assumption Realistic and Practical

Zero – Based Budgeting (ZBB):
Zero-based budgeting starts from zero and does not consider historical data. The income is
categorized into fixed costs, variable costs, and savings in such a manner that the balance
results in a zero.

Each expense item is evaluated from scratch and is taken only when its impact is justified—
based on current requirements and activities. Since there is no reference point if managers want
to invest more in marketing, for example, they can. They are starting from a zero, after all.

 Zero-based budgeting (ZBB) can be used for monthly, quarterly, semi-annual, and
annual budgets. Managers start from a nil balance and do not take the previous year’s
budget into account.
 Individuals, families, and companies can formulate zero based budgets.
 ZBB aims at cost-effectiveness. Every budget item becomes the direct result of profit
generation. For example, if the human resources department doesn’t make much profit
for the last few years, it will get less funding for the next year.
 Zero-based budgeting (ZBB) identifies irrelevant costs incurred by a business. The
ZBB method is applied along with other costing techniques—process costing, unit
costing, etc.
 In the 1960s, Peter Pyhrr was hired by Dallas-based; Texas Instruments where he
proposed zero-based budgeting. In 1970, he presented the concept at Harvard Business
Review, and in 1977, he published Zero Based Budgeting.

Features of Zero – Based Budgeting:

The prominent characteristics of zero-based budgeting that differentiates it from the

other budgeting methods are mentioned below:
1. Every zero based budget starts afresh, i.e., with a zero balance.
2. All the departments of a business entity together take the budgeting decisions.
3. It focuses on cost reduction.
4. Such a budget can be modified or adjusted with time.

Stages in Zero-based budgeting:

ZBB involves the following stages:
(i) Identification and description of Decision packages
(ii) Evaluation of Decision packages
(iii) Ranking (Prioritisation) of the Decision packages
(iv) Allocation of resources
(i) Identification and description of Decision packages: Decision packages are the
programmes or activities for which decision is required to be taken. The programmes or
activities are described for technical specifications, financial impact in the form of cost
benefit analysis and other issues like environmental, regulatory, social etc.
(ii) Evaluation of Decision packages: Once Decision packages are identified and
 described, it is evaluated against factors like synchronisation with organisational
objectives, availability of funds, regulatory requirement etc.
(iii) Ranking (Prioritisation) of the Decision packages: After evaluation of the decision
packages, it is ranked on the basis priority of the activities. Because of this
prioritization feature ZBB is also known as Priority-based Budgeting.
(iv) Allocation of resources: After ranking of the decision packages, resources are
allocated for decision packages. Budgets are prepared like it is done first time
without taking reference to previous budgets.

Advantages: It has the following advantages:

1) It provides a systematic approach for the evaluation of different activities and

rank them in order of preference for the allocation of scarce resources.
2) It ensures that the various functions undertaken by the organization are critical
for the achievement of its objectives and are being performed in the best possible
way.
3) It provides an opportunity to the management to allocate resources for various
activities only after having a thorough cost-benefit-analysis. The chances of arbitrary
cuts and enhancement are thus avoided.
4) The areas of wasteful expenditure can be easily identified and eliminated.
5) Departmental budgets are closely linked with corporation objectives.
6) The technique can also be used for the introduction and implementation of the
system of ‘management by objective.’ Thus, it cannot only be used for fulfillment
of the objectives of traditional budgeting but it can also be used for a variety of
other purposes.

Disadvantages: The following disadvantages of ZBB cannot be overlooked:

1) Profits Overemphasized: Every budgeting item becomes the direct result of whether it
generates profits or not. For example, if the human resources department doesn’t make
much profit for a few years, it will get less funding in the ZBB method.
2) Consumes Time and Manpower: ZBB requires a lot of effort—managers and
employees from different departments are involved. It is, therefore, very labour-
intensive. In addition, the collection and interpretation of data take a lot of time.
3) Requires Expertise: The budgeting method demands a lot of mathematical, accounting,
and analytical knowledge.
4) Centralizes Cost: Since it focuses on the cost factor and its reduction, essential
objectives like product quality and customer service get compromised.
5) Doesn’t Consider Sudden Expenses: This method fails to estimate immediate or
emergency expenses.
6) Confusion: When too many departments and individuals are involved, the inputs are
often contradictory.
Performance Budget

A performance budget is a budget that refers to programs, functions, and performance that
reflects the estimated expenses and revenues of the companies, Government, or Statutory
bodies. It is a budget that provides the objective and purpose for raising funds and proposed
activities and programs to be accomplished.
It is aimed to improve the efficiency of the people involved in performing the budgeted task as
per the budget.

Purpose: A performance budget is mainly aimed at evaluating whether the budgeted task is
being carried out as planned and measuring the performance involved in the budget procedure.
The purpose is to ensure the performance is as per the budgets and workings are being done
smoothly and the persons performing their task with utmost responsibility along with efficient
utilization of the funds raised and achieving the objectives.

Characteristics of Performance Budgets: Following are the characteristics:

Performance Budget Process: Below is the step by step process which takes place:

Performance Budget Examples

1. 80% reduction in the patients suffering from Malaria & Dengue by 2020.
 2. 20% decrease in manufacturing waste by introducing staff training in the manufacturing
process;
3. 50% reduction in the infant mortality rate through the successful implementation of
vaccination centers in different parts of the country by 2021;

Performance Budgeting: Performance budgeting (PB) involves evaluation of the

performance of an organisation in the context of both specific as well as overall objectives of
the organisation. This requires complete clarity about both the short-term as well as long-
term organisational objectives. The responsibility of the various levels of management
should be predetermined in terms of results expected from them and the authority vested in
them. In other words, performance budgeting requires fixing of the responsibility of each
executive in organisation and the continuous appraisal of his performance. It is, therefore,
considered to be synonymous with responsibility accounting.
Performance Budgeting provide a meaningful relationship between estimated inputs and
expected outputs as an integral part of the budgeting system. ‘A performance budget is
one which presents the purposes and objectives for which funds are required, the costs
of the programmes proposed for achieving those objectives, and quantitative data measuring
the accomplishments and work performed under each programme. Thus, PB is a technique
of presenting budgets for costs and revenues in terms of functions. Programmes and
activities are correlating the physical and financial aspect of the individual items comprising
the budget.

Traditional budgeting vs. Performance budgeting:

 The traditional budgeting 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.
 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 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.

Objectives: Performance budgeting seeks to:

1. correlate the physical and financial aspects of programmes and activities;
2. improve budget formulation, review and decision-making at all levels of management in
the government machinery;
3. facilitate better appreciation and review by the legislature;
4. make possible more effective performance audit;
5. measure progress towards long-term objectives as envisaged in the plan; and
6. bring annual budgets and developmental plans together through a common language.
Components of Performance Budget: The performance budgets have certain vital
ingredients that need to be constantly kept in view:
i. a programme and activity classification that represents the range of work of each
organisation;
ii. a framework of specified objectives for each programme;
iii. a stipulation of the targets of work or achievement; and
iv. suitable workload factors, productivity and performance ratios that justify financial
requirements of each programme.
Steps in Performance Budgeting:
According to the Administrative Reforms Commission (ARC) the following steps are
the basic ones in PB:
 Establishing a meaningful functional programme and activity classification of
government operations.
 Bring the system of accounting and financial management in accordance with this
classification.
 Evolving suitable norms, yardsticks, work units of performance and units costs,
wherever possible under each programme and activity for their reporting and
evaluation.
The Report of the ARC use the following terms in an integrated sequence:

Functions Programme Activity Project

The team ‘function’ is used in the sense of ‘objective’. For achieving objectives
‘programmes’ will have to be evolved. In respect of time horizon, it is essentially a
replacement of traditional annual fiscal budgeting by a more output-oriented, but still an
annual, exercise.
Advantages of Performance Budgeting
1. Improvement in Performance: The first and foremost advantage of performance
budgeting is that it helps in improvement in the performance of the department as well
as employees working in the department because both department head as well as
employees working in the department know that if they perform well then next year they
will get more budget allocation in their department by the company which results in
healthy competition between various departments of the company.
2. Helps in Motivating Employees: It also helps in motivating employees because when
employees know that company is watching the performance for allocation of budgets
then they will work hard because a higher budget would mean a higher scope of
development of not only the department of the company but also the employees of the
department working in the company. In simple words just when you do well in your
exams and your parents give a party to the whole family then your siblings and family
members also get to enjoy the party due to you doing well in exams same is the case
with the company where the whole department gets to enjoy the benefits of increased
performance budget from the company.
3. Increased Accountability: In case of the company giving or enhancing the
performance budget of departments of the company then it will psychologically put
more accountability in the minds of department heads as well as employees working in
the department of the company which in turn will lead to them giving their best effort
towards the achievement of set targets of the department by the company.

Disadvantages of Performance Budgeting

1. Biased: The biggest problem with performance budgeting is that chances of biases
creeping in while allocating budget on the basis of performance are high which in turn
can have an adverse effect on the morale of other employees who are working in the
company and are more deserving. In simple words, if your child is participating in a
debate competition and he or she has given his best performance but the judge
announces someone else the winner not because he or she has done well but because he
or she is known to judge then this is nothing but injustice same thing happens in
companies also where sometimes top management favor their favorite department head
and not the deserving department heads.
2. Performance is not Everything: The fact that in performance budgeting the emphasis
is laid only on performance is a negative thing because in the case of companies while
performance is important but other aspects like teamwork, creativity, interpersonal
relations are also needed in the company which is ignored under this method of
budgeting. Hence for example suppose the finance department head due to his or her
contact has sent some leads to the marketing department and that lead has converted into
sales than company following performance budgeting will reward the marketing
department which is not right as the sales is the result of the joint effort of both finance
and marketing department and not marketing department.
 3. Needs Constant Monitoring: It requires constant monitoring and supervision on the
part of the company so as to ensure that performance of each department is measured
which in turn can be a quite complex process and may lead to a lot of expense as well as
manpower on the part of the company.

Budget Ratio
Ratio is a mathematical relationship between two or more related figures. Budget ratios
provide information about the performance level, i.e., the extent of deviation of actual
performance from the budgeted performance and whether the actual performance is
favourable or unfavorable. If the ratio is 100% or more, the performance is considered as
favourable and if ratio is less than 100% the performance is considered as unfavourable.
The following ratios are usually used by the management to measure development from
budget.
1. Capacity Usage Ratio: This relationship between the budgeted number of working
hours and the maximum possible number of working hours in a budget period.
2. Standard Capacity Employed Ratio: This ratio indicates the extent to which
facilities were actually utilized during the budget period.

3. Level of Activity Ratio: This may be defined as the number of standard hours
equivalent to work produced expressed as a percentage of the budget of standard
hours.
4. Efficiency Ratio: This ratio may be defined as standard hours equivalent of work
produced expressed as a percentage of the actual hours spent in producing the work.
5. Calendar Ratio: This ratio may be defined as the relationship between the number
of working days in a period and the number of working as in the relative budget
period.

Budget Ratios:
Standard Hours
(i) Efficiency Ratio = ×100

Standard Hours
(ii) Activity Ratio = ×100
Budgeted Hours

Available working days

(iii) Calendar Ratio = ×100
Budgeted working days

(iv) Standard Capacity Usage Ratio =

Actual Hours worked

(v) Actual Capacity Usage Ratio = ×100
Max. possible working hours in a period

Actual working Hours

(vi) Actual Usage of Budgeted Capacity Ratio = ×100
Budgeted Hours
Differences Between Standard Costing and Budgeting Costing

Basis of
Standard Costing Budgeting Costing
Difference

Standard costs are predetermined or Budgeting costs are based on past

Base
planned costs. experience.

Budgeting costs are based on

Standard costs are based on technical
Technique historical data and adjusted to the
estimates.
future.

The standards are set for elements of Budgets are prepared for every
Scope
cost. business activity.

Standard costs can be used for Budgets are used for men,
Limited Use
estimation or forecasting. materials, and money.

Standard costs are used in ideal Budgets are made and used in
Conditions
conditions or situations. diverse conditions and situations.

Standard costs can be calculated per Budgeting costs cannot be

Per unit
unit. calculated on a per-unit basis.

Standards are set only Budgets are compiled for

Nature
for expenditure. both income and expenditure.

Standard cost is not comprehensive Budgeting cost coverage is

Coverage (i.e., it is limited only to cost significantly greater than standard
operations). cost coverage.

Standard costs cannot be specified in The budget can be in parts (only

Parts
parts. the cash budget).