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Budgeting - HL OnlyLearning Objective:

Explain the importance of budgeting fororganizations.

Calculate and interpret variances

Analyse the role of budgets and variancesin strategic planning.

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What is a Budget?

Describe in your groups what you think a budget is:

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Budget Defined

- A detailed financial plan for the future1.A Budget is a target for cost or revenue that a business or department must aim to reach over a period of time.2.It is an agreed pattern of income and expenditure which sets targets for revenue and expenditure over a given time in the future.It a method of turning a business’ strategy into reality.A budgeting system should allocate and monitor costs and revenue.IT is NOT a forecast… it is a TARGET.

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Key features of budgets

Budgets are plans for how much money should be spent on various items

They normally cover a 12 month period They are broken down into weekly or monthly

intervals They are set for each department in a firm The departmental manager is responsible for

ensuring that money spent is within budget limits The manager is called the budget holder

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Types of Budget:

IncomeSales Budget

ExpenditureProduction

Distribution Budget

Marketing Budget

Cash Budget

Master Budget

Material purchases

Staff Budget

Overheads Budget

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What is a budget for?

To ensure no department or individual spends more than the company expects.

To provide a yardstick against which a manager’s success or failure can be measured.

To enable spending power to be delegated to local managers who are in a better position to know how best to use the business’ money.

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The Purpose:

Define business goals Encourage analysis Focus on the future Communicate plans and instructions Coordinate business activates Provide basis for evaluating performance against

either past or expected results. Act as a motivating tool to exceed expectations. Control and monitor Planning Efficiency motivation

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Activity 1

Individually Analyse three problems that ‘AIS’ might have in setting up budgets for the next financial year.

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Activity 2

Move into pairsPick one problem from the group.Analyse it. (Level 5)Try to come up with a solution. (Level

6/7)

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Creating a budget

Forecast level of activity, eg sales, for the next year

Each department then produces a suggested budget based on the forecast

Suggested budgets are discussed with senior management, modified and agreed

The ‘budget year’ begins and managers receive regular feedback on spending.

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Budget plan 

PRODUCTION DEPARTMENT BUDGET

MARCH 2008 - FEBRUARY 2009

Item Monthly expenditure

$

Sheet aluminium

Wheels

Tyres

Wages

Maintenance

Electricity

Moulds

12,000

8,900

9,500

16,500

4,000

1,750

850

Total 53,500

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Flow diagram how to set a budget, explain each step in your own words.

- pg 207 - 208

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Setting Budgets

This is not an easy job. How do you decide exactly what level of sales are likely next year?

How do you plan costs? – raw material could fluctuate?

Most business use last years Budget as a guide, and make minor adjustments.

This is great as it takes little time to do.

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The best criteria for setting budgets

Incremental budgeting vs Zero Budgeting

Debate!

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Feedback on performance

Shortly after the end of the month (or week), the budget holder is given a list of actual expenditure on each item

The budget holder compares this with the budgeted amount

If there is a major overspend, action must be taken to try to solve the problem

Once a budget has been set up, the following events take place:

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Limitations & Benfits of budgeting

Advantages Disadvantages

Article in pack.

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Benefits of Budget control

Means of Controlling income and expenditure.

Management can Hand over responsibility

Ensure capital is fully employedHelp coordinate business and improve

communicationProvide Clear targets

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Drawbacks of Budget control (unit 2)

May lead to resentment of personnel (if not involved)

If inflexible business could suffer

If Budget results differ to budgeted amounts, may lose its control.

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Question:

8 marks

Your best mate has a great idea… he wants to open a ballerina shop at Ion. Tell him why you think he should set up a budget before he starts.

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Your best mate has a great idea… he wants to open a ballerina shop at Ion. Tell him why you think he should set up a budget before he starts.

C2 Ap 3 An3 Content 2 marks Two or more points made and

explained 1 mark Relevant content made but not

developed or one point made and explained

0 marks No relevant content points made. Application 3 marks Points effectively applied to the

case 2 - 1 mark An attempt to apply knowledge

to the case 0 marks No attempt at application Analysis 3 – 2 marks Good analysis of issues 1 mark Limited analysis of issues 0 marks No analysis of issues

demonstrated

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VARIANCES

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Budgets and variances

The difference between the planned and actual figures is called a variance.

A minus sign before the variance shows it is an overspend, eg

Budgeted amount: $200

Actual spending: $250

Variance: – $50

The use of a minus sign can be confusing, there is a better way.

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Variance

Variance is the amount by which the actual results differs the budgeted figure.

There are two types of variances:

Favourable Variance: is one, which leads to, higher than expected profit (revenue costs up or costs down).

Adverse Variance: is one that reduces profit, such as costs being higher than the budgeted level.

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Examples:

An expenditure budget allocates $3,000 for stationary, but spends $3,600

Adverse variance because costs $600 more than budgeted, so all other things being equal, the profit will be $600 less than budgeted.

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Examples:

A sales budget targets $8,000, but achieves $9,000

Favourable variance because sales are $1,000 more than budgeted, so all other things being equal, the profit will be $1,000 higher than budgeted.

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Analysis of variances

Budgets variances need to be monitored throughout the year (along with performance ratios & other statistical information)

Business are looking for the underlying reasons behind the variances.

What are the possible reasons for variances?

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Reasons for variances:

Calculation errorsChanges in plansExternal factors – fluctuations in demnsChanges in interest ratesInflation

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Variance

Regular variance statements provide an early warning.

If a product’s sales are slipping below budgets, managers can respond by increasing marketing support, or by cutting back on production plans

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Is budgeting worth while?

Pg 209 ‘Budget control & strategic planning’

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Managers need to be mindful:

Managers responsible for budgets should be clear of their responsibilities

Budget holders need to be accountable and must negotiate and inform when prices increase are affecting areas they have responsibility for.

If the business has made changes these need to be passed on.

All budget holders are responsible for contributing to the budget setting process.

Time tables for monitoring

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Types of variances and interpretation

A Business will begin by constructing a budget and then monitor the results of the budget.

It should be relatively easy to identify a variance and then calculate the exact variance.

The next problem is to analyse it and explain it and evaluate the significance.

A business will then seek to attribute responsibility for the variance and take corrective action.

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WHY, oh Why… does this happen???

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Variance Reason?

Sales variance Cost variance Materials variance Labour variance Overheads variance Profit variance

1. A price is greater/less than expected

2. Volume is greater than or less than expected

Can be a Combination of the two!

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Sales revenue variances

Sales revenue variances can be caused by:

Sales volume - Actual sold is difference from planned volume.

Sales price – difference in price being paid.

It is possible to work out the precise impact of the changes.

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It is possible to work out the precise impact of the changes.

Sales revenue variance =

(AQ x AP) – (BQ x BP)

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Sales revenue variance = (AQ x AP) – (BQ x BP)

AP = Actual price per unitAQ = Actual Quantity sold

BP = Budgeted price per unitBQ = Budgeted Quantity sold

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TYPES OF VARIANCE

DIRECT MATERIALS VARIANCE(AC – BC) × AQ PRICE VARIANCE(AP – BP) × AQ COST VARIANCE OF MATERIALS(AQ – B2) × BC TOTAL LABOUR COST VARIANCE(AR × AH) – (BR × BH) LABOUR RATE PRICE VARIANCE(AR – BR) × AH MATERIALS VARIANCE(AQ × A2) – (BQ × BC) SALES REVENUE VARIANCE(AQ × AP) – (BQ × BP) VOLUME OR QUANTITY VARIANCE(AQ – BQ) × BP

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Budget Control… Why bother?

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Benefits of Budget control

Means of Controlling income and expenditure. Provides a measure of performance Management can hand over responsibility Ensure capital is fully employed Help coordinate business and improve

communication Provide Clear targets Highlight problems early Use this for

analysis

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Drawbacks of Budget control

Planned in advanced therefore could be inaccurate

May lead to resentment of personnel (if not involved)

Failure to ‘hit’ budget’ might be de-motivating If inflexible business could suffer If Budget results differ to budgeted amounts,

may lose its control.

Use this for analysis

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Budgets and cashflow forecasts

Similarities

Estimated expenditure is forecastBoth are broken down into monthly

intervalsActual performance is compared with

the plan

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Budgets and cashflow forecasts

Differences

Budgets are for individual departments – not the business as a whole

One person is responsible for each budget

Most budgets are concerned only with expenditure. Cashflow forecasts cover both income and expenditure

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Different types of Budgets:

Historical budgetingZero budgetingFlexible budgeting

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Historical Budgeting

Use last years figuresProbable costs & revenueNeed small increase for inflationSeen as realisticCurrent circumstance can differDoesn’t take into account new aims and

objectivesDoesn’t encourage efficiency

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Zero Budgeting

An alternative method is Zero Budgeting.

Zero Budgeting sets each department budget at zero, and demands that budget holders, in setting their budget, justify every pound they ask for.

This helps to avoid the common occurrence of budgets going up each year.

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Zero budgeting 

Cost efficient Incorporates aims Everything is examined Is complicated and time consuming Managers have to compete.

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Flexible Budgets

Another type of Budgeting

These adjust the Budgeted figures in line with the actual sales volume achieved.

This insures that variances show changes in costs rather than a mixture of costs and sales volumes

Look at the following example: 

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Flexible Budgets

How can a manger identify the cause of the costs over run?

Costs are $12, 000 higher than forecasted, but that would be understandable if the demand had increased by 10 %.

But if demand was the same if could be because they were paying more for raw material.

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Flexible Budgets

In flexible budgeting they allow for changes in sales volume.

Eg. If sales increased by 10% the flexed budget would add 10% to the budgeted figure.

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Flexible Budgets

Budgets are kept up-to-dateNo set budget, no agreed targetsCan use uncontrollable external factors

as excusesTry to impress by reducing targets that

they know they can exceed.

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Which method of Budgeting do you recommend for your friend the ballerina? And why…..

Historical budgetingZero budgetingFlexible budgeting