budgeting

Section O: Budgeting

Aims for this session

  • Define the term budget.

  • Explain the role and use of budgets.

  • Define, calculate, and interpret budget variances.

  • Understand possible causes of adverse and favorable variances and how businesses can utilize this information.

What is a budget?

  • A financial plan for the future concerning the revenues and costs of a business.

Budgeting Introduction

  • Budgeting is the process of setting targets that cover all aspects of revenues and costs.

  • A budget is a detailed financial plan covering both income (revenue) and expenditure (costs) over a specified time period.

  • Budgets inform managers about how much they can spend to achieve objectives.

  • Budgets can be created for the entire business or specific departments.

  • Budgets are plans that are agreed upon in advance.

Budgetary Control

  • Budgets for income/revenue and expenditure are prepared in advance.

  • Comparison with actual performance to identify variances is essential.

  • Variance: A difference between actual and budget figures.

    • Can be Positive/Favorable (better than expected) or Adverse/Unfavorable (worse than expected).

Responsibilities in Budgetary Control

  • Managers are responsible for controllable costs within their budgets.

  • Must take action if adverse variances are excessive.

Uses of Budgets

  • Establish priorities and set targets.

  • Turn objectives into practical reality.

  • Provide direction and coordination.

  • Allocate resources effectively.

  • Delegate responsibilities without losing control.

  • Improve overall efficiency.

  • Forecast outcomes.

  • Monitor performance.

  • Control income and expenditure.

Principles of Good Budgetary Control

  • Clearly defined managerial responsibilities.

  • Managers must adhere to their budgets.

  • Performance is regularly monitored against the set budget.

  • Corrective actions are applied if results differ significantly from the budget.

  • Investigate unaccounted variances.

  • Departures from budgets require senior management approval.

Approaches to Budgeting

Historical Budgeting

  • Uses last year’s figures as the foundation for budgeting.

  • Realistic, based on actual results, but may not reflect current circumstances.

  • Does not promote efficiency.

Zero Budgeting

  • Starts with a budget of zero; budget holders must justify the need for funds.

  • Requires building the budget from the bottom-up based on new proposals.

  • More complex and time-consuming, but can be more realistic.

Understanding Variances

  • A variance occurs when actual figures differ from budgeted figures.

  • Types of variances:

    • Positive/Favorable: Better performance than budgeted.

    • Adverse/Unfavorable: Worse performance than budgeted.

Favourable and Adverse Variances

Favourable Variance

  • Actual figures exceed budgeted:

    • Costs lower than expected.

    • Revenue/profits higher than expected.

Adverse Variance

  • Actual figures are below budgeted:

    • Costs are higher than expected.

    • Revenue/profits lower than expected.

Illustration of Variances

Item

Budget (£'000)

Actual (£'000)

Variance (£'000)

Favourable/Adverse

Sales revenue Standard product

75

90

15

Favourable

Premium product

30

25

-5

Adverse

Total sales revenue

105

115

10

Favourable

Costs

Wages

35

38

3

Adverse

Rent

15

17

2

Adverse

Marketing

20

14

-6

Favourable

Other overheads

27

35

8

Adverse

Total costs

97

104

7

Adverse

Profit

8

11

3

Favourable

  • Analysis shows favorable variances in standard product sales and profit overall, with adverse variances in costs.

Causes of Favourable Variances

  • Examples:

    • Lower interest rates lead to higher-than-expected sales.

    • Bad publicity for competitor products increase sales.

    • Unions agree to lower wage settlements than budgeted.

    • Favorable exchange rates reduce import costs.

Causes of Adverse Variances

  • Examples:

    • Competitors offering enticing price deals resulting in lower sales.

    • Decreased staff efficiency leading to increased labor costs.

    • Rising oil prices causing higher energy costs.

    • Rent increases leading to unexpected expenditures.

Why Good Isn't Always Good

  • A favorable variance on raw material costs may indicate use of cheaper, lower-quality materials, which could be detrimental.

Why Bad Isn't Always Bad

  • An adverse variance in labor costs might signify that higher-skilled employees are providing better quality work, which is beneficial.

Do Variances Matter?

  • Importance depends on:

    • If they were foreseen or foreseeable.

    • Size in absolute money terms and relative size in percentage terms.

    • Underlying cause.

    • If it is a temporary issue or indicative of a long-term trend.

What to do about a Variance

  • Act only on variances outside an agreed margin; avoid wasting time.

  • Investigate significant variances to determine causes.

  • Distinguish between avoidable and unavoidable variances.

  • Take appropriate remedial actions if necessary.

How Budgets Can Be Utilized

  • Management by Exception: Focus on activities requiring attention, not those running smoothly.

  • Budget control analyses highlight deviations from preset standards.

  • Issues showing no or small variances do not require action; attention should focus on major adverse variances.

Problems and Limitations of Budgets

  • Accuracy is contingent on the data used.

  • Budgets may result in inflexibility.

  • Budgets need revision as circumstances change.

  • Management of budgets is time-consuming.

  • There is a risk of making short-term decisions to adhere to budgets at the expense of long-term strategies.

Summary

  • Prepare questions and bring them to LL1 for discussion.