Module 2

Meaning of Public Expenditure:

Expenses incurred by the public authorities—central, state and local

self- governments—are called public expenditure. Such expenditures
are made for the maintenance of the governments as well as for the
benefit of the society as whole.

There was a misbelief in the academic circles in the nineteenth century

that public expenditures were wasteful. Public expenditures must be
kept low as far as practicable. This conservative thinking died down in
the twentieth century, especially after the Second World War.

As a modern state is termed a ‘welfare state’, the horizon of

activities of the government has expanded in length and breadth. Now
we can point out the reasons for enormous increase in public
expenditure throughout the world even in the capitalist countries
where laissez-faire principle operates. These are the following.

Causes of Increase in Public Expenditure:

(a) Size of the Country and Population:

We see an expansion of geographical area of almost all countries. Even

in no-man’s land one finds the activities of the modern government.

Assuming a fixed size of a country, developing world has seen an

enormous increase in population growth. Consequently, the expansion
in administrative activities of the government (like defence, police, and
judiciary) has resulted in a growth of public expenditures in these
areas.

(b) Defence Expenditure:

The tremendous growth of public expenditure can be attributed to

threats of war. No great war has been conducted in the second half of
the twentieth century. But the threats of war have not vanished; rather
it looms large. Thus, mere sovereignty, demands a larger allocation of
financial sources for defence preparedness.

(c) Welfare State:

The 19th century state was a ‘police state’ while, in 20th and 21st
centuries modern state is a ‘welfare state’. Even in a capitalist
framework, socialistic principles are not altogether discarded. Since
socialistic principles are respected here, modern governments have
come out openly for socio-economic uplift of the masses.
Various socio-economic programmes are undertaken to promote
people’s welfare. Modern governments spend huge money for the
purpose of economic development. It plays an active role in the
production of goods and services. Such investment is financed by the
government.

Besides development activities, welfare activities have grown

tremendously. It spends money for providing various social security
benefits. Social sectors like health, education, etc., receive a special
treatment under the government patronage. It builds up not only social
infrastructure but also economic infrastructure in the form of transport,
electricity, etc.

Provision of all these require huge finance. Since a hefty sum is

required for financing these activities, modern governments are the
only providers of money. However, various welfare activities of the
government are largely shaped and influenced by the political leaders
(Ministers, MPs, and MLAs to have a political mileage, as well as by the
bureaucrats (MPLAD)).

(d) Economic Development:

Modern government has a great role to play in shaping an economy.

Private capitalists are utterly incapable of financing economic
development of a country. This incapacity of the private sector has
prompted modern governments to invest in various sectors so that
economic development occurs.

Economic development is largely conditioned by the availability of

economic infrastructure. Only by building up economic infrastructure,
road, transport, electricity, etc., the structure of an economy can be
made to improve. Obviously, for financing these activities, government
spends money.

(e) Price Rise:

Increase in government expenditure is often ascribed to inflationary

price rise.

Principles Governing Public Expenditure or Canons of Public

Expenditure:

Rules or principles that govern the expenditure policy of the

government are called canons of public expenditure. Fundamental
principles of public spending determine the efficiency and propriety of
the expenditure itself. While making its spending programme,
government must follow these principles. These principles, in short, are
called canons of public expenditure.
Findlay Shirras has laid down the following four canons of
public expenditure:

(i) Canon of benefit

(ii) Canon of economy

(iii) Canon of sanction

(iv) Canon of surplus

(i) Canon of Benefit:

According to this canon, public spending has to be made in such a way

that it confers greatest social benefits. In other words, public
expenditure must not be geared in such a way that it provides benefits
to a particular group of the community. Thus, public expenditure is to
be made in those directions where general benefits rather than specific
benefits flow in.

However, often public expenditure is incurred for the benefit of a

particular group (say, dalits, tribals). This sort of public expenditure
does not violate canon of benefit. Any public expenditure for the
development of a backward area does promote social interest.

(ii) Canon of Economy:

Economy does not mean miserliness. It refers to the avoidance of

wasteful and extravagant expenditure. Public expenditure must be
made in such a way that it becomes productive and efficient. Efficiency
in public expenditure requires economy of expenditures. To enjoy the
maximum aggregate benefit from any public spending programme, it is
necessary that the canon of economy is observed.

An uneconomic expansion in public expenditure will result in scarcity of

funds, the much-needed growth of the productive sectors will be
hampered. This means lower social benefit. It is thus obvious that the
canon of economy is not independent of the canon of benefit.

(iii) Canon of Sanction:

The canon of section, as suggested by Shirras, requires that public

spending should not be made without any concurrence or sanction of
an appropriate authority. Arbitrariness in public spending can be
avoided only if spending is approved. Further, economy in public
spending can never be ensured if it is not sanctioned.

(iv) Canon of Surplus:

This canon suggests the avoidance of deficit in public spending. Like
individuals, saving is a virtue for the government. So the government
must prepare its budget in such a way that government revenue
exceeds government expenditure so as to create a surplus. It must not
run deficit to cover its expenditure.

However, modern economists do not like to attach any importance to

Shirras’ fourth canon— the canon of surplus. To them, deficit financing
is the most effective means of financing economic programmes of the
government.

Importance of Public Expenditure:

An old-fashioned dictum says that “The very best of all plans of

finance is to spend little, and the best of all taxes is that which
is least in amount.” No one today believes this philosophy. In the
1930s, J. M. Keynes emphasized the importance of public expenditure.

The modern state is described as the ‘welfare state’. As a result, the

activities of the modern government have widened enormously.
Modern governments are undertaking various social and economic
activities, particularly in less developed countries (LDCs).

i. Economic Development:

Without government support and backing, a poor country cannot make

huge investments to bring about a favourable change in the economic
base of a country. That is why massive investments are made by the
government in the development of basic and key industries,
agriculture, consumable goods, etc.

Public expenditure has the expansionary effect on the growth of

national income, employment opportunities, etc. Economic
development also requires development of economic infrastructures. A
developing country like India must undertake various projects, like
road-bridge-dam construction, power plants, transport and
communications, etc.

These social overhead capital or economic infrastructures are of crucial

importance for accelerating the pace of economic development. It is to
be remembered here that private investors are incapable of making
such massive investments on the various infrastructural projects. It is
imperative that the government undertakes such projects. Greater the
public expenditure, higher is the level of economic development.

ii. Fiscal Policy Instrument:

Public expenditure is considered as an important tool of fiscal policy.

Public expenditure creates and increases the scope of employment
opportunities during depression. Thus, public expenditure can prevent
periodic cyclical fluctuations. During depression, it is recommended
that there should be more and more governmental expenditures on the
ground that it creates jobs and incomes.

On the contrary, a cut-back in government’s expenditure is necessary

when the economy faces the problem of inflation. That is why it is said
that by manipulating public expenditure, cyclical fluctuations can be
lessened greatly. In other words, variation of public expenditure is a
part of the anti- cyclical fiscal policy.

It is to be kept in mind that it is not just the amount of public

expenditure that is incurred which is of importance to the economy.
What is equally, if not more, important is the purpose of such
expenditure or the quality of expenditure. The quality of expenditure
determines the adequacy and effectiveness of such expenditure.
Excessive expenditures may cause inflation.

Moreover, if the government has to impose taxes at high rates there

will be loss of incentives. So, it is necessary to avoid unnecessary
expenditure as far as practicable, otherwise benefits of better
economic development may not be reaped. As a fiscal policy
instrument, it may be counter-productive.

iii. Redistribution of Income:

Public expenditure is used as a powerful fiscal instrument to bring

about an equitable distribution of income and wealth. There are good
much public expenditure that benefit poor income groups. By providing
subsidies, free education and health care facilities to the poor people,
government can improve the economic position of these people.

iv. Balanced Regional Growth:

Public expenditure can correct regional disparities. By diverting

resources in backward regions, government can bring about all-round
development there so as to compete with the advanced regions of the
country.

This is what is required to maintain integration and unity among people

of all the regions. Unbalanced regional growth encourages
disintegrating forces to rise. Public expenditure is an antidote for these
reactionary elements.

Thus, public expenditure has both economic and social objectives. It is

necessary to ensure that the government’s expenditure is made solely
in the public interest and does not serve any individual’s interest or
that of any political party or a group of persons.
Classification of Public Expenditure
Different economists have classified public expenditure on different bases.
We shall now study some of the important classifications of public
expenditure.

A) Revenue Expenditure
Revenue expenditure of the government is for incurred carrying out day-
to-day functions of the government departments and various services. It is
incurred regularly. For example, administration costs of the government,
salaries, allowances and pensions of government employees, medical and
public health services, etc.

B) Capital Expenditure
Capital expenditure of the government is expenditure for the progress and
development of the country. For example, huge investments in different
development projects, loans granted to the state governments and
government companies, repayment of government loans, etc.

C) Developmental Expenditure
Developmental expenditure is productive in nature. The expenditure
which results in the generation of employment, increase in production,
price stability, etc. is known as a developmental expenditure. For
example, expenditure on health, education, industrial development,
social welfare, Research and Development (R & D) etc.
D) Non-Developmental Expenditure
On the other hand, that government expenditure that does not yield any
direct productive impact on the country is called non-developmental
expenditure. For example, administration costs, war expenditure, etc.
These are unproductive in nature.
E) Productive Expenditure
Expenditure on infrastructure development, public enterprises or
development of agriculture increase productive capacity in the economy
and bring income to the government through tax and non-tax revenues.
Thus they are classified as a productive expenditure.
F) Unproductive Expenditure
Expenditures in the nature of consumption, such as defence, interest
payments, expenditure on law and order, public administration do not
create any productive asset which can bring income or returns to the
government. Such expenses are classified as unproductive expenditures.

G) Plan Expenditures
Refer to the spending of the annual funds allocated by the Central
government for development schemes outlined in the ongoing Five Year
Plan. For example: Industrial Development, Agricultural Development,
Infrastructure, Education & Health etc.
H) Non-Plan Expenditures
Include all those expenditures of the government that are not included in
the ongoing Five-Year Plan. They include both development and non-
development expenditure. Part of the expenditure is obligatory in nature
e.g. interest payments, pensions etc. and a part is essential obligation e.g.
defence and internal security.

Wagner’s Law of Increasing State Activity

Explanation:
In 1883, Adolph Wagner (1835-1917), a German political economist,
based on his study of public expenditure in industrial nations, propounded
a law called “The Law of Increasing State Activity”. Wagner’s law is
classified as a positive theory of public expenditure. It emerged in
response to the absolute as well as relative growth experienced by the
Western world during the second half of the 19 th century and in the
20th century.

Wagner opined that the economic development of a nation leads to an

increase in the activities and functions of the government. He explains
that in progressive societies, governments at central and local levels
constantly undertake new functions while they also perform old functions,
and this leads to a regular increase in the activity of the government. The
aim of government activities is to satisfy the economic needs of the
people more efficiently and more completely so that there is an increase,
extensive as well as intensive, in such activities and hence public
expenditure.

Therefore, public sectors in industrializing nations grow as a proportion of

total economic activity with the increase in per capita income and output,
i.e., the share of government expenditure in total output increases
inevitably. Although Wagner has based his study on industrial nations but
according to him, the law is equally applicable in the case of developing
countries.

Wagner views the relationship between the state and its citizens as such
that the state exists independently of the individuals in society, but it has
general responsibility for the economic and social welfare of society as a
whole. According to him, a state performs three functions: providing
administration and protection, ensuring stability and ensuring
social and economic welfare of society.

According to Herber (1979), the hypothesis explains that “a fundamental

cause-and-effect relationship exists between the growth of an
industrializing economy and the relative growth of its public sector…
relative growth of the government sector is an inherent characteristic of
industrializing economy”. He further explains the hypothesis as efforts to
find a predictable, long-run functional relationship between certain causal
variables and relative public sector growth.
Graphic Presentation of Law:

Wagner’s Law of Increasing State Activities

Figure 1 shows the relative expansion of public sector economic activity
over an extended period of time. On the horizontal and vertical axis, real
per capita income (Y) and real per capita output of public goods (PG) are
measured, respectively. PG1 represents a constant proportional increase
in the real per capita output of public goods with the increase in real per
capita income, whereas PG2 indicates that the public sector grows at an
increasing rate. In other words, a proportional increase in the public sector
is not constant but increases with the increase in total economic activity.

We now present some empirical evidence on the applicability of Wagner’s

law. Goode (1986) analyses the growth of public expenditure for a period
of 80 years (Table 1). He calculates the ratio of total government
expenditures (of all levels of government) to GNP or GDP (in percent) in
the case of five industrial countries at two points in time-1890 and 1970.
The rising trends of government expenditures as a proportion of national
income confirm the validity of Wagner’s law.

Table 1:

Country 1890 1970

Canada 9 32
 France 14 49

Germany 13 32

United Kingdom 9 33

United States 7 30

(Souce- Richard Goode, Government Finance in Developing Countries,

1986)

Criticism
Wagner’s hypothesis is criticised in the context of the relationship
between the state and its citizens as viewed by him. The law’s
applicability at all times and to all societies is also questioned by Peacock
and Wiseman. They have criticised Wagner’s hypothesis on three counts:

 The law is not applicable to all the western nations.

 As the law analyses long-term trends of public expenditure, it
tends to ignore the process of growth of public expenditure.
 It does not analyse the effect of war on public expenditure.

Peacock-Wiseman Hypothesis: Explanation, Graph & Criticism

Explanation
Alan T. Peacock and Jack Wiseman conducted a study of the behaviour of
government expenditure in the UK for the period 1890 to 1955. Their
study was based on Wagner’s hypothesis of increasing state activity.

The study analyses the time pattern of public expenditure. It explains

some important characteristics of the growth of the public sector. It is
argued that growth in public expenditure involved spurts of growth
followed by long static periods rather than a smooth and continuous
growth pattern, i.e. in a step-like pattern coinciding with social crises and
wars.

They explain the hypothesis with the help of three types of effects through
which public expenditure
increases: displacement, inspection and concentration effect.
The displacement effect is explained by comparing public expenditure in
times of peace and times of social disturbances as they see that the
expenditure cannot be the same at these two times. They were of the
view that the government likes to increase its expenditure as it has to
take care of society’s welfare. Besides, some disturbances at times may
also lead to an increased need for government expenditure, which may
not be met from existing public revenue. However, the fact that citizens
do not like to pay taxes puts a constraint on government spending.

The government expenditure is constrained by what they call a ‘tolerable

level of taxation’, which remains quite stable during times of peace. With
the growth in national income, tax revenue would also grow at a constant
‘tolerable’ tax rate. It enables the public expenditure to grow gradually.

This gradual trend is disturbed by social crises such as wars, famines or

other economic problems during which higher taxes also become
acceptable to society as the government needs higher public revenue to
meet unanticipated expenditures. The relative expansion in government
activity at times of social disturbances displaces the previous level of
government expenditure, which they termed as the displacement effect.

They also argued that this displaced public expenditure does not fall back
to the original level, i.e. it remains displaced at this level even after the
crisis. Peacock and Wiseman argued that an increase in public
expenditure does not tend to be smooth and continuous rather it
increases in a jerk or step-like fashion.

The Inspection Effect takes place when people observe and accept the
greater social spending required to fulfil social needs during the crisis. It
happens as society realizes that it carries a new, higher tax burden. In
other words, new levels of tax tolerance emerge.

The Concentration (scale) Effect is the tendency for central government

economic activity to become an increasing proportion of the total public
sector economic activity during times of economic growth of a society.

Gupta (1967) subjected the displacement hypothesis to empirical testing

in the case of five countries and found an upward displacement,
confirming the validity of the hypothesis. Dada and Adesina (2013)
attempted to examine the validity of the Peacock-Wiseman hypothesis in
the case of government expenditure and revenue in Nigeria, covering the
period 1961 to 2010. It was found that the hypothesis holds in the short
run as well as the long run. Government spending induced the growth of
public revenue during the reference period.

Graphic Presentation of Hypothesis

In the Figure, the step-like pattern of growth of public sector revenue and
expenditures in Great Britain during the period 1890 to 1955. Government
fiscal activities rise step by step to successive new plateaus, and this
spurt of growth is followed by a long static period. The steps indicate the
periods of major social disturbance. After every step, a new, higher tax
and expenditure level displaces the old, lower levels.

Peacock-Wiseman Hypothesis

Criticism
Peacock-Wiseman hypothesis recognized the importance of public
expenditure during social crises. Still, it has failed to explain the limit after
which an economic problem can be qualified as a ‘social crisis’.

Budgeting –Purposes, Types, Process and Zero Base Budgeting

Introduction

Time and money are scarce resources to all individuals and

organizations. The efficient and effective use of these resources requires
planning. Planning alone, however, is insufficient. Control is also
necessary to ensure that plans actually are carried out. A budget is a tool
that managers or planners use to plan and control the use of scarce
resources. A budget is a plan showing the company’s objectives and how
management intends to acquire and use resources to attain those
objectives. A budget can be made for a person, family, group of people,
business, government, country, multinational organization, or just about
anything else that makes and spends money. The budgeting process is
carried out to identify whether the person or organization can continue to
operate with its projected income and expenses. Therefore, the budget
should be objective driven which means that the expected revenues and
expenditures of each department will ultimately be based on the
organizational objectives.

Budget and Budgeting – Meaning and Concept

Budget

A budget is a financial or quantitative statement prepared for a definite

period of time.

OR

A budget is a financial plan that is used to estimate the revenue and

expenses over a specified future period of time.

OR

A budget is a detailed financial plan that quantifies future expectations

and actions relative to acquiring and using resources. The first and most
important step to effective financial planning is developing and
implementing a budget.

In order to make effective decisions and coordinate the decisions and

actions of the various departments, businesses need to have a plan for
profitability. Typically, a business creates a budget annually which, once
approved, becomes the Annual Plan (Budget).

OR

Budget refers to a comprehensive plan in writing, stated in monetary

terms that outline the expected financial consequences of management’s
plans and strategies for accomplishing the organization’s mission for the
coming period.

OR

A budget is a master financial document or a “blueprint for action that

set out the expected contribution from the operation or control of an
organization in terms of anticipated cash flows or revenues and expected
expenditures over a certain period of time.

Budgeting

Budgeting is the process of preparing the budget.

OR
Budgetingis the process of preparation, implementation and operation
of budgets decisions into specific projected financial plans for relatively
short periods of time. In other words, budgeting is the process of
“translating financial resources into human purposes” (Wildavsky, 1986).
OR
Budgeting is also viewed as a process of identifying, gathering,
summarizing and communicating financialinformation of an organization’s
future activities.
OR
Budgeting are formal statements of the financial resources set aside for
carrying out specific activities in a given period of time. They are most
widely used means for planning and controlling the activities at every
level of an organization.

Budgetary control:
Refers to any management approach that involves settingsome kind of
targets, regularly measuring variances betweenthe original targets and
actual outcomes, and motivating people to reduce those variances.

CHARACTERISTICS OF BUDGET
As stated earlier, a budget is a blueprint for management action. The
following are thecommon features of budget:

 A budget is quantitatively stated: The figures in the budget are

expressed I in monetary terms. However, non-monetary information
such as units to be sold, units to be purchased and others support
the monetary figures.
 A budget is prepared in advance: A budget must be drawn up
beforethe periodto which it refers. Figures produced during or after
the period may be important, but they are not part of a budget.
 A budget relates to a particular period:Generally, the budget is
prepared forone year. However, in the case of a seasonal business,
there may be two budgets for each year – a slack season budget
and a peak season budget.
 A budget is a plan of action: A budget is a plan because it
concerns actions to be taken rather than a passive acceptance of
future trends. Planning is the establishment of objectives and the
formulation, evaluation andselection of the policies, strategies,
tactics and action required to achieve the objectives. Like all plans,
budgets seldom turn out to be totally correct predictions of the
future. Conditions may change during the budget period, which
renders the budgetto be inaccurate. Even so, budget is useful in
guiding the actionsof managers.
 A budget is an estimation or prediction of profit
potential:The budget set forth the expenses and revenues planned
during the budget period and thereby reveal its profit potential.

Types of Budget:
The budget can be classified into following types:

 Sales Budget
  Production Budget
 Purchase Budget
 Selling and Distribution cost Budget
 Administrative Cost Budget
 Cash Budget
 Capital Expenditure Budget
 Master Budget

1. Sales Budget: The starting point for any business is sales. All the
activities of the business are dependent on sales. Therefore, it is
necessary to prepare sales budget. Accuracy in sales budget is very
important as all the other budgets are based on sales budget. If
something goes wrong in sales budget, then other activities are
affected.
2. Production Budget: Another important budget, which is wholly
dependent on sales budget, is the production budget. This budget
specifies the quantity of goods to be manufactured during the
budget period. It also includes the estimated cost for materials and
labor etc.
3. Purchase Budget: the purchase department prepares this budget.
Through this budget, the quantity is estimated and is given in the
form of purchase budget.
4. Selling and Distribution cost Budget: This budget includes the
total selling and distribution cost to be incurred in sales budget.
5. Administrative Cost Budget: This budget includes all the
administrative expenses to be incurred during budget period. The
Administrative expenses include salaries, transportation, insurances
etc.
6. Cash Budget: The cash budget is prepared to assess the total
requirements of cash for the budget.
7. Capital Expenditure Budget: This budget includes the amount of
capital expenditure needed for capital during the budget period.
8. Master Budget: Master budget is the sum total of all the budgets
for the budget period.

Purpose of Budgeting
Budget helps to aid the planning of actual operations by forcing
managers to consider how the conditions might change and what steps
should be taken now and by encouraging managers to consider problems
before they arise. It also helps to co-ordinate the activities of the
organization by compelling managers to examine relationships between
their own operation and those of other departments. The main purpose of
budgeting is:

 To control resources
 To communicate plans to various responsibility center’s managers.
 To motivate managers to strive to achieve budget goals.
 To evaluate the performance of managers
 To provide visibility into the company’s performance
  For accountability -It is a means for Executive Management to gain
consensus on how the year’s resources are going to be allocated
towards realization of the company’s quantifiable goals for the year.
 A Goal Setting Exercise.
 Provides a Metric for Assessing organization’s Performance.
 Acts as an Approval Process

Components of Budgeting Process

To be effective, the budgeting process should have several key

components. These are: Clearly Defined Goals, Effective Communication,
Management Involvement, Coordination, and Actual Performance
Reporting.

 Clearly Defined Goals

The Financial Goals of the organization need to be defined at the

beginning of the process. A typical goal would be for example, revenue
growth at 20%, net income growth of 10% and departmental operating
expense growth at varying growth levels. Typically, depending on the
organization, each division or department has different growth
expectations depending on the type of the organizations. The
organization’s that have significant research and development activities,
for example, usually allocate a larger amount to research and
development expenses. The process of developing the goals begins with
an analysis of the current year’s performance and an understanding of
what relationships exist to revenue, fixed and variable.

 Effective Communication

In order for the Management Team to be able to translate the Goals into
an operating budget, effective communication is imperative. First, a
timetable needs to be developed to set expectations and to determine
deadlines. A organization meeting to communicate the process is
desirable to ensure everyone receives the same message. A budget
package is distributed to management with information to help develop
budgets. The package should contain a rolling forecast updated with
actuals, employee detail for headcount planning, the defined goals with
specifics related to each department, a digital worksheet to aid both the
development of the budget and any upload or consolidation process, and
a financial calendar which includes deadlines and responsibilities.

 Management Involvement

For the process to be effective, Management buy-in is essential both in

the planning process and during the year to monitor and manage actual
performance. One purpose of the budgeting exercise is to achieve
consensus by everyone even though they are all competing for the same
resources. It is not possible for everyone to be able to add all the
headcount they desire or spend the amount of money they would prefer.
In addition, each department has a different perspective on what is
necessary to achieve the company’s goals and the importance of their
contribution. By the end of the process, everyone will have had to
compromise and should understand where their interests all intersect with
the organization’s goals.

 Coordination

Someone needs to be in charge of the process and drive towards the

deadlines. It is common for it to fall within the Chief Financial Officer’s
responsibilities. Absent that position, at the direction of the Chief Financial
Officer, it usually belongs in the Controller’s responsibilities. Preparing the
information for goal setting, creating the worksheets, consolidating the
information and being available to facilitate the process are all
responsibilities of this position.

 Actual Performance Reporting

Important to the effectiveness of the process is regular comparison of

actual performance to the budget. In addition to the inclusion of budgets
in the financial statement comparisons, many decisions should be made
with the budget in mind. For example, headcount additions and fixed
asset acquisitions should be evaluated if they were not budgeted
expenses. Many organizations allow expenditures that were approved in
thebudget process but require extensive justification.

Process of Budgeting

Budgeting is the process of identifying, gathering, summarizing and

communicating financial information of an organization’s future activities.
The task of budgeting and monitoring of budgets is an ongoing process.
Monitoring involves checking the targets, feedback, and so on. The
budgeting process involves the following procedures:

1. Define the objectives of the organization

First, the management tries to set the organizational objectives. These

would include identifying the profits, market share and other targets to be
achieved. The targets should be realistic that are made studying the
potential of the organization and the market situation.

2. Set production, marketing and financial budget

There are three major functional budgets and each is dependent on the
organizational objectives.
  Production Budget: It is expressed in quantitative terms only and
is geared to the sales budget. It involves costs of raw material,
direct labor costs, costs of purchasing components, and so on. This
is an expenditure-only budget.

 Marketing Budget: It is a combination of both the income and

expenses. It involves revenue from sales forecasted and expenses
involved in actualizing the marketing strategy.

 Financial budget: The financial budget depicts projected cash

flow. It helps to identify if the funds are in a proportion to cover the
expenses or not. If not, the management can find alternatives to
raise additional funds.

3. Fragmentation of budget: Each of the above stated budget is

then broken down, so that there could be different budgets like
training budget, sales budget, and so on.

4. Budget monitoring procedures establishing: As per the

business objectives and the internal environment of the business,
appropriate budget monitoring procedures must be established.

5. Identify variances: Any variances in the projected budgets must

be identified and responded too.

6. Feedback: The experience and knowledge achieved while setting

the budget for one period must be utilized while deciding on the
budget for another period.

Advantages of budgeting

 It helps to monitor and control operations.

 It provides a framework of delegation.
 It creates a sense of responsibility among the managers.
 It can improve communication systems within the organization.
 It promotes forward thinking.
 It also helps in coordination of different departments and align them
towards shared objectives.

Limitations of Budgeting

 It can demotivate employees if they do not get an opportunity to

participate in the budgeting process.
 It is difficult to estimate all the revenues and expenditure in
advance.
 It can result in building perceptions of unfairness.
 If budgets are inflexible, then it fails to reflect the necessary
changes.
  Budgeting might result in competition among the departments for
resources.

Zero Base Budgeting (ZBB)

Zero Base Budgeting is a system where each function, irrespective

whether it is old or new must be justified wholly each time a new budget
is made. It requires each manager to give details of the budget from
scratch or zero bases as if it were the first ever budget of the
organization.

Zero Base Budgeting process involve four basic steps:

(i) Identification of activities for which budget has to be prepared.

(ii) Analysis of each activity and ranked on the basis of benefits to the
organization
(iii) Evaluation and decision to select the activities
(iv) Allocation of resources to each activity

Advantages and Disadvantages of Zero Based Budgeting

Zero-based budgeting encourages you to use all of your monthly income

for specific purposes. That doesn’t mean that you get to go on a shopping
spree every time you get a paycheck. It simply dictates that all of your
money gets allocated to a specific purpose. That means you will manage
your savings, expenses, and debt payments so that your income
subtracted by your expenditures always equals zero.

It is up to you to label expense categories. You can repeat some of them,

change your monthly contribution amounts, and mix things up in
whatever way is necessary. When you come under budget in a specific
category at the end of the month, then you add the remaining amount to
the next budget or send it to an emergency fund.

If you grew up using the envelope system as a way to save your

allowance, then this method will feel very familiar.

Several advantages and disadvantages of zero-based budgeting are worth

taking into consideration.

List of the Advantages of Zero-Based Budgeting

1. It keeps you aware of your cash flows.
When you are using a zero-based budget, then you are entirely aware of
how much money is going into and out of your accounts each month. This
method makes it easier to stop spending on credit – which is money that
you don’t really have at the moment. If you aren’t tracking where your
cash is going each month or it feels like your spending is out of control,
then this option can get you back into a better place of financial security.
2. You can customize the budget to fit your specific needs.
If you are new to managing money or have specific needs to meet each
month, then zero-based budgeting gives you a way to handle your
expenses effectively. You can add or subtract line-item needs each month
so that you always know where your cash is going. This recognition makes
it easier to find places where you could cut back on your expenses so that
you can establish an emergency fund, save for a vacation, or pay for the
costs of youth sports.
This advantage makes it a lot easier to keep corporate legacy expenses in
check. Traditional budgeting might not examine this issue for several
years, waiting until an economic shock disrupts the system. Since costs
tend to grow over time, teams cut budgets instead of looking at costs.
When done correctly, the zero-based budgeting avoids issues with myopic
views.

3. It looks at the reasons why you are spending money.

Traditional budgeting processes look at how much you are spending every
time an expense occurs. The zero-based budgeting method also takes into
account the reasons why you make spending decisions. It looks at the root
of each choice that you make, steering you toward specific objectives –
even at an organizational level. Instead of looking at what you
accomplished in the past, it ignores your previous habits to focus on the
present.
The goal is to correct any spending behaviors that rob your financial
health of its full potential. Once that work gets done, then you can
manage the rest of your budget. A good approach to take is to spend 50%
of your budget on needs, 30% on your wants, and 20% on debt. How you
would classify a mortgage (needs vs. debt) depends on what you hope to
accomplish with your efforts.

4. It shows places for improvement each month.

The preparation of zero-based budgeting comes with the same
assumption that a base from a previous period isn’t required. Self-
employed individuals may make an exception to this advantage if their
income is variable. You’ll then analyze expenses for the month, quarter, or
year to ensure that every spending habit comes from a necessary place
and provides a tangible benefit in some way.
5. Zero-based budgeting can discontinue obsolete processes.
The zero-based budget seeks to find inefficiencies in your financial
systems by eliminating anything that isn’t useful to your overall monetary
health. That means any obsolete process from a personal or commercial
standpoint will get found and removed so that you’re not spending on
things that you’re not using. It’s like the idea of having four streaming
services, but you’re only using one of them each month. This budget
would have you eliminate the three that you don’t use.
When you can discontinue obsolete processes, then businesses achieving
better costing and pricing. That means more profitability within the
organization. If you can achieve a similar outcome with your personal
finances, then it is possible to establish a savings account that actually
starts to grow.

6. It quickly detects inflated budgets.

If you have too much money in a specific line item in your budget, then
the zero-based budgeting method will detect the issue quickly. It looks at
the exact amount that you need for a specific review period with the
expectation that you run out of money there. When you have a remaining
balance, then this indicates that other areas of your finances need more
attention.
If you run out of cash there, then it can indicate a problematic area in your
spending that also requires attention.

7. This budget can identify opportunities for outsourcing.

The zero-based budgeting approach looks at cost-savings opportunities
from a variety of perspectives. If you can save money without sacrificing
the quality of your needs or wants, then it can highlight places where
outsourcing might be possible. If you look at this advantage from a
residential standpoint, then it might suggest moving from a full-time
housekeeper to a cleaning service that works on a contracted basis.
Companies often use the zero-based budgeting method to identify over-
staffed areas since labor costs tend to be the largest expenditure faced.

8. Zero-based budgeting creates a need to justify each

expenditure.
Whether it is a need or a want, the zero-based budgeting method forces
people to make choices about their spending habits. You must have a
specific reason for every purchase that you make. If there isn’t a valid
justification to pursue something, then this approach suggests that you
shouldn’t change your cash flows.
That’s why this method facilitates an effective delegation of authority,
especially from a corporate viewpoint. Instead of having money move
unpredictably based on dozens of different perspectives, you can have
one group or team in control of the decisions. Families can take a similar
approach where one person manages a majority of the financial decisions.

9. It encourages more initiative and responsibility.

Today’s money isn’t always tangible money. Most people use a cashless
approach to their spending because of its simplicity. Why try to manage
cash when you can just swipe a debit card that takes what you owe out of
your checking account?
The zero-based budgeting encourages initiative and responsibility
because you must work with the numbers and physical cash. You must
communicate and collaborate across your family or a company so that
your spending gets coordinated. That makes it much easier to identify
what your high impact costs are versus the ones that have a low or
medium impact.

You are always in total control of the budget.

Every dollar has a job when you’re using the zero-based budgeting
method. That’s why it controls mindless spending effectively. When you
know where your cash flows need to go each month, then it’s easier to
understand what you need to do. If you need to change something, then
you can always move a few dollars here and there to create a new line
item. It familiarizes you with your accounts, spending habits, and money
handling abilities.

List of the Disadvantages of Zero-Based Budgeting

1. It takes a lot of time to manage a zero-based budget.

If you are going to hold yourself accountable to your overall budget, then
you must closely monitor your spending every month. Because every
household faces a set of variable expenses, it can be a challenge to create
this structure if you’re new to budgeting. You must account for irregular
costs every month or this approach can leave you without enough money
to take care of everything.
You’ll want to set money aside for these costs through a savings fund that
becomes part of your “needs” category. It must be separate from your
emergency fund, retirement goals, and other savings measures and
receive monthly contributions.

2. Having an unpredictable income can make this budgeting

method impossible to use.
The zero-based budgeting method works best when you have predictable
monthly income levels. If you work as a freelancer, in the gig economy, or
as an independent contractor, then you never know how much money to
allocate each month. Even hourly workers with fluctuating schedules can
encounter this disadvantage. You can use the income from the previous
month as a budget for the next one, but that also means having the ability
to have a month’s worth of income as a savings buffer to maintain the
budget.
3. A zero-based budget has more subjectivity in the decision-
making process.
Some of your expenses can be challenging to classify as a need or a want.
How you decide things are essential is based on your personal
perspective. There are qualitative considerations where value goes
beyond the cash that you’ve got available, which means numbers, needs,
and wants can’t be your only points of reference.
What if you go to a massage therapist twice per month for migraines?
How do you classify Christmas presents in your budget? One family might
perceive youth sports as a need, while another could see it in the “want”
category. There is no consistency, and that means the achievable results
can be highly variable.

4. It could be detrimental to your long-term financial goals.

The zero-based budgeting method looks at a cost-benefit analysis in the
present time. That means you’re accounting for all of the cash flows in a
specific snapshot. You’re not looking toward the future or reliving the
past. That means an expense that could feel like a long-term need is seen
in the present tense as a short-term want.
Imagine that you have about $50 extra per month. Your child wants to
participate in soccer, which is an optional expense. The zero-based
budgeting method might suggest that you avoid that cost, but then what
happens if that stops your child from earning a scholarship? Long-term
investments are not always a priority.

5. Zero-based budgeting may have some flexibility, but it is also

rigid.
The goal of zero-based budgeting is to avoid debt whenever possible. It
can be an essential practice that eliminates problems with credit card
spending because you’re only using the money that you earn each month.
This rigidity can also create problems when you run out of cash in your
budget for some reason.
Even if you have an emergency fund and a separate area of expenses for
unusual charges, there can be incidents that overwhelm your finances for
the month. The rigidity of this approach dictates that you take money
from other places, which eventually means something gets sacrificed.

6. It requires financial skills to implement.

Conflicts can arise when taking the zero-based budgeting approach
because it requires a significant amount of skill and time to implement. If
that is not available within a household, then there isn’t a way to
implement this method successfully. You can always take time to learn
how to manage finances like this from industry experts, but then that
means you’re taking another commitment that you may not have time to
manage.

Summary

Budgeting is the process of identifying, gathering, summarizing

and communicating financial information of an organization’s future
activities whereas,a budget is a plan showing the organization’s objectives
and how management intends to acquire and use resources to attain
those objectives. The budget can be made for a person, family, group of
people, business, government, country, multinational organization, or just
about anything else that makes and spends money. The budgeting
process is carried out to identify whether the person or organization can
continue to operate with its projected income and expenses. Therefore,
the budget should be objective driven which means that the expected
revenues and expenditures of each department will ultimately be based
on the organizational objectives.