Business Analysis and Strategy: Budgeting and Financial Performance

Variance

A variance is any unplanned change from the budgeted figure. They occur when an actual figure for sales or expenditure differs from the budgeted figure.

Favourable Variance

A favourable variance exists when the difference between the actual and budgeted figures will result in the business enjoying higher profits than shown in the budget.

Adverse Variance

An adverse variance occurs when the difference between the figures in the budget and the actual figures will lead to the business' profits being lower than planned.

Budget

A budget is a financial plan for the future; without such a plan, businesses and individuals often get into financial trouble.

Sales Revenue Budget

Sales revenue budgets set out a business' planned revenue from selling its products. Important information includes expected level of sales and the likely selling price of the product.

Expenditure Budget

Expenditure budgets set out a business' planned expenditure on labour, raw materials, fuel and other items essential for production.

Zero Budgets

It involves managers starting with a clean sheet where they must justify all expenditure.

Advantages of Budgeting

A means of controlling income and expenditure, regulate the spending of money and highlight losses, waste and inefficiency.

Disadvantages of Budgeting

They can be time consuming for managers in small businesses; especially for those who are not particularly numerate.

Reasons for Changes in Variances

Favourable sales variances might be caused by factors such as an effective bonus scheme for salesmen, a successful advertising campaign, favourable weather, and the demise of a competitor.

Adverse Sales Variances Causes

Adverse sales variances might be caused by several factors, including the successful activities of competitors, losing an important contract, ineffective advertising, logistical problems, bad weather, and general economic conditions.

Favourable Cost Variances Causes

Favourable cost variances might have been caused by factors such as workers being better trained/motivated, reduced costs of imported components due to a strengthening of Sterling, and falling raw material costs.

Budgeted Sales Revenue

Budgeted sales revenue is set at £2850,000.

Actual Sales Revenue

Actual sales revenue is £2420,000.

Sales Revenue Variance

The sales revenue variance is £430 adverse.

Budgeted Cost of Sales

Budgeted cost of sales is £1980,000.

Actual Cost of Sales

Actual cost of sales is £1760,000.

Cost of Sales Variance

The cost of sales variance is £220 favourable.

Budgeted Gross Profit

Budgeted gross profit is £870,000.

Actual Gross Profit

Actual gross profit is £660,000.

Gross Profit Variance

The gross profit variance is £210 adverse.

Motivation from Budgeting

Budgets can act as a motivator for staff if the budget is met.

Coordination through Budgeting

They help in the co-ordination of a business and improve communication between different sections of the business.

Adverse cost variances

Might have been caused by several factors, including significant differences between actual and budgeted figures.

Depreciation

The difference between what the value was and what it is now, representing the fall in the value of fixed assets due to use, time, or obsolescence.

Straight-line method of depreciation

Assumes that a fixed asset depreciates an equal amount each year of its expected useful life.

Calculation of depreciation

Original Cost - Residual Value divided by Expected life of the asset (years).

Annual rate of depreciation

Calculated as (original cost - residual value) / life expectancy.

Yearly value of a vehicle after 1 year

Calculated as (£10,000 - £2,000) = £8,000.

Yearly value of a vehicle after 2 years

Calculated as (£8,000 - £2,000) = £6,000.

Yearly value of a vehicle after 3 years

Calculated as (£6,000 - £2,000) = £4,000.

Yearly value of a vehicle after 4 years

Calculated as (£4,000 - £2,000) = £2,000.

Purpose of budgeting

To reflect the true value of a firm's assets and to avoid overvaluation.

Legal requirement for depreciation

To devalue fixed assets in order to reflect their true worth.

Impact of window-dressing accounts

It would affect the company's reputation and may impact their ability to borrow money.

Factors causing adverse cost variances

New/cheaper suppliers, strikes by workers, bad weather, fewer workers employed, unexpected price rises from suppliers.

Budget significance

Can lose its significance if actual figures are very different from budgeted ones.

Importance of training/motivation

Better trained/motivated workers can lead to improved production outcomes.

Budget flexibility

Budgets must not be too inflexible as opportunities might be missed.

Depreciation example

A vehicle bought for £10,000 with a residual value of £2,000 after 4 years.

Depreciation calculation example

For a vehicle, annual depreciation is (£10,000 - £2,000) / 4 = £2,000.

Budget types

Three types of budget include fixed, flexible, and zero-based budgets.

Poorly constructed budgets

Can lead to poor decision making.

Budget Variance

The difference between the actual income, expenditure or profit and the figure that had been budgeted.

Variance Analysis

The process of calculating and interpreting variances.

Adverse Variance

A variance that is bad for the business.

Favourable Variance

A variance that is good for the business.

Actual Income

The real income received, as opposed to what was budgeted.

Budgeted Income

The income that was planned or expected to be received.

Expenditure

The amount spent, which can be compared to the budgeted figure.

Profit

The financial gain, calculated as income minus expenditure.

Internal Inefficiency

A possible cause of variances due to poor management of a budget.

Action of Competitors

A possible cause of variances due to lower prices or new products introduced by competitors.

Internal Decision Making

Decisions made within the organization that can impact budget variances.

Action of Suppliers

Changes made by suppliers that can affect costs, such as changing prices or offering discounts.

Changes in the Economy

Economic factors that can impact actual expenditure and/or income.

Interest Rates

A change in interest rates that can affect borrowing costs and budget variances.

Minimum Wage Increase

An increase in minimum wage that can impact expenditure and budget variances.

Stakeholders

Individuals or groups that have an interest in the performance and decisions of a business.

Investors

Stakeholders who assess proposed spending levels and measure actual expenditure to judge performance.

Employees

Stakeholders who negotiate personal targets and link rewards to meeting budgets.

Managers

Stakeholders who communicate expectations and assess performance of functions within the business.

Del Rio Pizzeria

A business concerned with high waste levels and low customer numbers after 6 months of trading.

Budget

A financial plan that outlines expected revenues and expenses over a specific period.

Actual

The real financial performance figures that occur during a specific period.

Variance

The difference between budgeted and actual figures, indicating performance discrepancies.

Pizza Sales

Sales revenue generated from pizza, totaling £55,000 budgeted and £48,000 actual.

Drinks Sales

Sales revenue generated from drinks, totaling £18,000 budgeted and £20,500 actual.

Materials

Costs associated with materials, totaling £27,500 budgeted and £1,500 favourable actual variance.

Drinks stock

The value of drinks stock, totaling £9,000 budgeted and £10,250 actual.

Wages

Total wages expense, totaling £23,000 budgeted and £1,000 adverse actual variance.

Overheads

Total overhead costs, totaling £40,000 budgeted and £43,000 actual.

Profit / Loss

The financial result of a business's operations, calculated as total revenues minus total expenses.

Budget Variance

The difference between the budgeted amount and the actual amount spent or earned.

Sales Turnover

Total sales revenue generated by a business during a specific period.

Opening Stock

The value of inventory available at the beginning of a trading period.

Purchases

Total costs incurred for acquiring goods during a specific period.

Fixed Assets

Items owned by the business which do not change in the short term, such as buildings and machinery.

Closing Stock

The value of inventory available at the end of a trading period.

Cost of Sales

All costs of production used, including direct costs like raw materials and wages.

Gross Profit

The difference between sales revenue and cost of sales.

Net Profit

The profit remaining after all expenses have been deducted from gross profit.

Current Assets

Assets that can be quickly converted into cash, such as stock and debtors.

Current Liabilities

Obligations that must be paid within 12 months, such as overdrafts and creditors.

Long-term Liabilities

Debts that will take more than a year to pay back, such as bank loans.

Capital Employed

The total money invested in the business, including shareholders' funds and retained profit.

Formula for Gross Profit

Sales Revenue - Costs of Sales.

Formula for Net Profit

Gross Profit - Expenses.

Total Expenses

The sum of all costs incurred by the business during a specific period.

Balance Sheet

A formal financial document that summarises the net worth of a business at a given point in time.

Working Capital

A measure of a firm's liquidity/ability to meet day to day expenses.

Working Capital Formula

Working capital = current assets - current liabilities.

Capital Employed

The value of all long-term finance that has been invested.

Capital Employed Formula

Capital employed = long-term liabilities + shareholders' capital.

Shareholders' Capital

Shareholders' capital = share capital + retained profit and reserves.

Depreciation

The reduction in value of an asset over time, particularly for fixed assets.

Current Assets

Likely to be turned into cash within a year.

Current Liabilities

Debts that the business may have to repay within one year.

Non-current Assets

Items likely to be kept by the business for more than one year.

Non-current Liabilities

Debts that the business has more than one year to repay.