Business Functions (Budgeting, Sales Forecasting, The Income Statement)

Budgets

A financial target for the future concerning the revenues and costs of a business

Variance

The difference between the target revenue and the actual revenue

Uses of budgeting

- establish priorities and set targets
- turn objectives into practical reality
- provide direction and co-ordination
- assign responsibilities
- communicate targets
- allocate resources
- motivate staff, improve efficiency
- monitor performance

Historical budget

A budget based on previous budgets
- realistic in that it is based on actual results
- however circumstances may have changed
- does not encourage efficiency

Zero-Based Budget

Budget costs and revenues are set at zero
- based on new proposals for sales and costs
- makes budgeting more complicated and time-consuming but potentially more realistic

Types of budget

Revenue (income) budget
- expected revenues and sales broken into more detail
Cost (expidenture) budget
- expected costs based on sales budget
- overheads and other fixed costs
Profit budget
- based on the combined sales and cost budgets
- of great interest to stakeholders

how a budget is constructed

- analyse the market
- draw up sales budget
- draw up cost budget

To key sources of info for budgets

- financial performance in previous periods (esp. for established businesses)
- market research

Difficulties in budgeting accurately

sales forecasting
- harder when markets experience rapid change
- start ups find it hard to estimate likely sales and revenue
- competitor actions hard to predict
costs
- always likely to be unexpected costs
- will vary depending on the sales budget
- change in external environment will impact costs

Variance Analysis

Calculating and investigating the differences between actual results and the budget.

A variance arises when there is a difference between actual and budget figures - variances can be:

Favourable (better than expected)
Adverse (worse than expected)

Possible causes of favourable variances

- stronger market demand than expected \= higher actual revenue
- SP increased higher than budget
- cautious sales and cost assumptions
- competitor weakness
- better than expected productivity or efficiency

Possible causes of adverse variances

- unexpected events lead to unbudgeted costs
- over-spends by budget holders
- sales forecasts prove over-optimistic
- market conditions means SP are lower then budget

Whether variances matter depends on...

- was the variance foreseen?
- size (absolute size in money terms/relative size in percentage terms)
- cause
- whether it was a temporary problem or the result of a long term trend

Variances allow 'management by exception'

- since it highlights areas of the business which differ fro what is expected
- in terms of revenue or cost that show no or small variances require no action - instead management concentrate on items showing a large adverse variance

What should management do with a variance?

- act only if the variance is outside an agreed margin
- investigate the cause
- act to remedy the problem

Adverse variance

might come from something that is good that has happened to the business eg higher production costs because sales are significantly higher

Limitations of budgets

- are only as good as the data being used
- can lead to inflexibility in decision making
- need to be changed as circumstances change
- take time to complete and manage
- can result in short term decisions to keep within the budget

Behavioural implications of budgets

- demotivating if imposed rather than negotiated, or unrealistic
- can contribute to departmental rivalry - battles over budget allocation
- spending up the budget to preserve it for next year

Zero budgeting advantages

- cost efficiency can be improved
- allocation of funds can be better targeted
- motivation can be increased
- coordination can be enhanced

Zero budgeting disadvantages

- budgeting becomes more complex
- the process could become more political and divisive

Budgetary control advantages

enables a business to:
- plan ahead
- improve efficiency
- improve coordination
- set targets
- delegate responsibility
- motivate

Budgetary control disadvantages

may cause problems when budgets are:
- too rigid and inflexible
- a source of conflict
- unfairly or inaccurately prepared
- viewed by the business as the only important targets

advantages of cost and profit centres

- enables firms to identify specific areas of the business that are inefficient or making a loss
- enables budgetary control to be exercised at lower level for smaller units
- motivational

disadvantages of cost and profit centres

- allocating costs is not always straightforward
- may lead to conflict rather than coordination
- additional responsibility to achieve budget targets for sales or costs may prove demotivating

Cash flow forecasting

The process of estimating the expected cash inflows and cash outflows over a period of time

cash flow is important

- cash flow is a dynamic + unpredictable part of life for most businesses
- cash flow problems are the main reason why a business fails
- regular and reliable cash flow forecasting can address many of the problems

Cash inflows

cash sales, receipts from trade debtors, sale of fixed assets, loans from bank, share capital invested

Cash outflows

payments to suppliers, wages and salaries, tax on profits, interest, dividends

Why is cash important?

- to pay suppliers
- to prevent failure
- to pay overheads

Net cash flow

Total inflows - total outflows

Why produce a cash flow forecast?

Advanced warning of cash shortages
Makes sure the business can pay employees and suppliers
Important part o financial control
Provide reassurance to investors and lenders that the business is being managed properly

A good cash flow forecast...

Is updated regularly, makes sensible assumptions, allows for unexpected changes

A cash flow problem

when a business does not have enough cash to be able to pay its liabilities on time

Solutions to solve financial problems

- get a bank overdraft
- ask for a longer trade credit time
- reduces wages
- get a loan
- reducing advertising
- buy in bulk
- change to a cheaper supplier

Problems with cash flow forecasts

- sales prove lower than expected
- customer do not pay up on time
- costs prove higher than expected
- imprudent assumptions

The income statement

A financial statement showing the revenue and expenses for a fiscal period.

Constructing the income statement

- the income statement is designed to calculate profits
- revenue
- cost of sales (costs involved in the manufacturing of the product)
- gross profit (revenue - cost of sales)
- overheads (fixed costs)
- operating profit (gross profit - overheads)
- finance costs (interest)
- net profit (profit before tax)

Gross Profit

an indicator of how efficient the business is at making and selling its products
- a calculation is used to help us judge the efficiency of the business

Gross Profit Margin

Gross profit/sales revenue x 100
- the better the performance the higher the gross profit margin will be

Variations in the GPM between businesses are caused by both internal and external factors

Internal
- size of the business
- the quality of stock control
- management of expenses
External
- level of interest rates
- the type of the market it is in
- the target market

Net profit

An indicator of how profitable the business is overall: this is because all the business's revenues and expenses in its calculation are involved

Net Profit Margin

Net profit/sales revenue x 100
- one factor that will lower the NPM is if the business is relatively new

Analysing the NPM

- an NPM of 18% + may be regarded as good, indicating effective business management of costs and expenses
- an NMP of 10-17% might be viewed as satisfactory, but cost or expenses management could be improved
- an NPM of less than 10% could be regarded as poor, indicating that there are real opportunities for improving cost and expenses management

How to increase GPM?

1. increase revenue
2. decrease cost of sales

Increase revenue

- increase or decrease price depending on the PED
- increase promotion
- increase output/distribution/target markets

Decrease cost of sales

- renegotiate with current supplier
- reduce staffing costs
- decrease cost of deliveries