Unit 2: Managing a business Finance Using budgets Chapter 16

Unit 2: Managing a business

Finance

Using budgets

Chapter 16


Finance

What is a budget?

A budget is an agreed plan establishing, in numerical or financial terms, the

policy to be pursued and the anticipated outcomes of that policy.

In Unit 1 the setting of budgets was discussed. The focus was on planning

a budget.

In Unit 2 the actual using of budgeting is studied. How can budgeting help

the business to improve its performance?


Finance

Benefits and drawbacks of using budgets

Benefits• They provide direction and coordination. • They can motivate staff. • They improve efficiency. • They encourage careful planning.

Drawbacks• They are difficult to monitor fairly. • Allocations may be incorrect and unfair. • Savings may be sought that are not in the interests of the firm. • They may be inflexible.


Finance

Features of good budgeting

A good budget should:• be consistent with the aims of the business• be based on the opinions of as many people as possible• set challenging but realistic targets (be SMART)• be monitored at regular intervals• be flexible


Finance

Variance analysis

variance analysis: the process by which the outcomes of budgets are examined

and then compared to the budgeted figures. The reasons for any differences

(variances) are then found.

favourable variance: when costs are lower than expected or revenue is higher

than expected.

adverse (unfavourable) variance: when costs are higher than expected or

revenue is lower than expected.


Finance

Calculating variances

A variance is calculated by the following formula:

variance = budget figure – actual figure

For variance analysis, use ‘F’ for favourable variances and ‘A’ for adverse variances,

rather than positive or negative numbers.

A favourable variance would happen when:• actual income is greater than budgeted income• actual costs are below budgeted costs

An adverse (or unfavourable) variance would be shown when:• actual income is less than budgeted income• actual costs are above budgeted costs


Finance

Calculating variances: the golden rule

The golden rule: knowing the effect a variance has on profit tells you whether it is

favourable or adverse.

A favourable variance will mean more profit than expected.

An adverse variance will mean less profit than expected.


Finance

Example variance calculation: income budget

Income budget for XYZ Ltd, April 2009

Source of

income

Budgeted

income (£)

Actual income

(£)

Variance (£) F/A

Product A 7,500 7,600 100 F

Product B 6,000 5,700 300 A

Total income 13,500 13,300 200 A


Finance

Example variance calculation: expenditure budget

Expenditure budget for XYZ Ltd, April 2009

Item of

expenditure

Budgeted

expenditure

(£)

Actual

expenditure

(£)

Variance (£) F/A

Raw materials 2,700 2,500 200 F

Labour costs 2,400 2,450 50 A

Administration

and other costs

4,500 4,500 0 –

Total

expenditure

9,600 9,450 150 F


Finance

Example variance calcualtion: profit budget

Profit budget for XYZ Ltd, April 2009

Item of

income/

expenditure

Budgeted

profit (£)

Actual profit

(£)

Variance (£) F/A

Total income 13,500 13,300 200 A

Total

expenditure

9,600 9,450 150 F

Budgeted profit 3,900 3,850 50 A


Finance

Interpreting the variances

1 What factors might have caused the variances for XYZ Ltd?

In small groups find:

a Two factors WITHIN the business that might have led to the variances in the

INCOME budget.

b One factor OUTSIDE the business that might have led to the variances in the

INCOME budget.

c Two factors WITHIN the business that might have led to the variances in the

EXPENDITURE budget.

d One factor OUTSIDE the business that might have led to the variances in the

EXPENDITURE budget.

2 Suggest two actions the business might take to improve matters.


Finance

Interpreting the variances: answers

Possible answers include:

1a

• Successful marketing of product A.• Low-quality production of product B.

1b• Adverse media publicity concerning product B.

1c• Efficient production methods, leading to lower wastage of raw materials.• Workers being given a wage rise that was higher than expected.

1d

An unexpected shortage of raw materials, leading to higher prices being charged by suppliers.

2• Introduce new quality assurance measures for product B.• Investigate alternative suppliers or different raw materials.


Finance

Calculating variance: income budget

Complete the variance analysis for XYZ Ltd’s income budget.

The budgeted income column has been provided.

Actual income for XYZ’s two products were:• product A: 3,000 units were sold at a price of £2.70• product B: 6,400 units were sold at a price of £1.25

Income budget for XYZ Ltd, May 2009

Source of income Budgeted

income (£)

Actual income

(£)

Variance (£) F/A

Product A (3,200 x £2.50) 8,000

Product B (6,000 x £1.30) 7,800

Total income 15,800


Finance

Calculating variance: expenditure budget

Complete the variance analysis for XYZ Ltd’s expenditure budget.

The budgeted expenditure column has been provided.

Actual expenditure was as follows:• Raw materials were 25% of the actual income.• Labour costs were 25p per unit (9,400 × 25p).• Administration and other costs were £4,200.


Finance

Expenditure budget for XYZ Ltd, May 2009

Item of expenditure Budgeted

expenditure

(£)

Actual

expenditure

(£)

Variance (£) F/A

Raw materials (25% of

£15,800)

3,950

Labour costs (9,200 x 25p) 2,300

Administration and other

costs

4,600

Total expenditure 10,850


Finance

Calculating variance: profit budget

Complete the variances for XYZ Ltd’s profit budget, based on your variances for the

income and expenditure budgets.

Profit budget for XYZ Ltd, May 2009

Item of

income/

expenditure

Budgeted

profit (£)

Actual profit

(£)

Variance (£) F/A

Total income 15,800

Total

expenditure

10,850

Budgeted profit 4,950


Finance

Income budget: answers

Income budget for XYZ Ltd, May 2009

Source of income Budgeted

income (£)

Actual income

(£)

Variance (£) F/A

Product A (3,200 x £25) 8,000 8,100 100 F

Product B (6,000 x £13) 7,800 8,000 200 F

Total income 15,800 16,100 300 F


Finance

Expenditure budget: answers

Expenditure budget for XYZ Ltd, May 2009

Item of expenditure Budgeted

expenditure

(£)

Actual

expenditure

(£)

Variance (£) F/A

Raw materials (25% of

£15,800)

3,950 4,025 75 A

Labour costs (9,200 x 25p) 2,300 2,350 50 A

Administration and other

costs

4,600 4,200 400 F

Total expenditure 10,850 10,575 275 F


Finance

Profit budget: answers

Profit budget for XYZ Ltd, May 2009

Item of

income/

expenditure

Budgeted

profit (£)

Actual profit

(£)

Variance (£) F/A

Total income 15,800 16,100 300 F

Total

expenditure

10,850 10,575 275 F

Budgeted profit 4,950 5,525 575 F


Finance

Interpreting the variances

What were the main factors that led to the variance in XYZ’s profit for May 2009?

Possible answers are:• The price increase for product A led to a small fall in demand, which led to sales

revenue increasing. (Lower volume would also have saved on variable costs.)• The price cut for product B led to a significant rise in demand and an increase in

income (but a rise in variable costs too).• There was a major cut in administration costs of almost 10%.• Although variable costs rose per unit produced, they were the same as the

budget.

Conclusion: the main reason for the favourable variance in profit was the significant

saving in administration and other costs. The price changes of both products also

helped to boost income.


Finance

Using budgets: follow-up exercise

Complete the questions in case study 1 at the end of Chapter 16.


Finance

Chapter 17

Improving cash flow


Finance

Causes of cash-flow problems

cash flow: the amounts of money flowing into and out of a business over a period of

time.

Firms may have shortages of cash for a variety of reasons:• seasonal demand• overtrading, arising from over-expansion• over-investment in fixed assets• credit sales• poor stock management• poor management of suppliers• unforeseen change, e.g. a strike• losses or low profits


Finance

Ways of improving cash-flow problems (1)

There are many ways of improving cash flow. The method(s) chosen may vary

according to the cause of the cash-flow problem. The AQA specification identifies five

main ways of improving cash-flow problems. These are shown on this slide and the

next:• Bank overdraft. An agreement whereby the holder of a current account in a

bank is allowed to withdraw more money than there is in the account. • Short-term loan. This is a sum of money provided to a firm or an individual for

a specific, agreed purpose. Repayment of the loan will usually take place within 2

years.


Finance


• Factoring. When a factoring company (usually a bank) buys the right to collect

the money from the credit sales of an organisation.• Sale of assets. This process can improve cash flow by converting an asset

(e.g. property or machinery) into cash, which can then be used to ease the

problem.• Sale and leaseback of assets. Assets that are owned by the firm are sold to

raise cash and then rented back so that the company can still use them for an

agreed period of time.

The benefits and problems of using each of these five methods of improving cash

flow are discussed after the next slide.


Finance


Some other ways of improving cash flow (not specified in the AQA specification) are

listed below:• Careful cash management (e.g. setting aside a contingency fund for

emergencies).• Effective debt management — chasing up customers who have not paid on

time.• Stock management — making sure that money is not tied up in excessively

high stock levels.• Diversifying to create a range of products that sell throughout the year. • Careful budgeting.


Finance

Benefits of a bank overdraft

• It is easy to arrange and, once agreed, tends only to need confirming on an

annual basis. • It is very flexible, as the overdraft can be used to pay for whatever the business

requires at the time. • Interest is only paid on the level of the overdraft that is actually used.

Furthermore, interest is only paid on a daily basis. • Unlike with a bank loan, a firm that uses a bank overdraft does not need to

provide security (collateral).


Finance

Problems of a bank overdraft

• Bank overdrafts are based on flexible interest rates, so it is difficult to budget

accurately — the bank may change its rate of interest.• The rate of interest charged on an overdraft is usually higher than that charged

on a short-term bank loan.• Agreements to provide an overdraft normally allow the bank to demand

immediate repayment.


Finance

Benefits of short-term loans

• Bank loans are usually at a fixed rate of interest. The interest and repayment

schedule is calculated at the time of the loan, so it easy for the business to know

whether it can afford to repay the loan and budget for repayment. • The rate of interest charged on a bank loan is usually less than that charged on

an overdraft, so it can be a cheaper solution to a cash-flow problem.• A bank loan may be set up for a long period of time, to help the firm.


Finance

Problems of short-term loans

• Interest is paid on the whole of the sum borrowed. • The business will need to provide the bank with security (collateral). • Short-term loans can often only be used for a specific, agreed purpose.


Finance

Benefits of (debt) factoring

• Improved cash flow in the short term. • Lower administration costs. • Reduced risk of bad debts. • Can encourage businesses to be cautious and careful with their provision of

credit, to ensure that all debts are factored.


Finance

Problems of (debt) factoring

• The main problem is the cost to the business, which will lose between 5% and

10% of its revenue. • The factoring company will charge more for factoring than it would for a loan, as

there are administrative expenses involved in chasing up the debts. • Customers may prefer to deal directly with the business that sold them the

product. An aggressive factoring company may upset certain customers, who will

blame the original seller of the product.


Finance

Benefits of sale of assets

• Selling assets can raise a considerable sum of money, particularly in the case of

a large asset such as a building.• If a particular asset is no longer helping towards the business’s overall success,

sale of the asset will not only ease the cash-flow problem, but also enhance the

overall profitability of the business.


Finance

Problems of sale of assets

• Assets such as buildings and machinery may be very difficult to sell quickly. A

business trying to make a quick sale usually has to accept a much lower price

than its true value. • It is a fundamental principle of business that a firm should not sell fixed assets to

improve liquidity, as the fixed assets enable it to produce the goods and services

that create its profit.


Finance

Benefits of sale and leaseback

• This will overcome a cash-flow problem by providing an immediate inflow of

cash, usually of quite a significant level. • A firm can be more flexible, as new and more efficient assets can be leased. • The ownership of fixed assets can lead to a number of costs, such as

maintenance. Sale and leaseback eliminates these costs.• Owning an asset can distract a business from its core activity because it has to

get involved with activities such as property management or organising a

transport fleet.


Finance

Problems of sale and leaseback

• In the long term, the firm will usually pay more in rent than it receives from its

sale. • As a result, sale and leaseback will also reduce the value of the firm’s assets that

can be used as security against future loans. • The business may eventually lose the use of the asset when the lease ends, as a

competitor may be prepared to pay a higher rental for the lease.


Finance

Finding the causes of a cash-flow problem: group exercise

Find three or four possible causes of the forecast cash-flow problems in the situation below.

* In quarters 2 and 3, customers will be given 6 months’ credit when they buy product A, to boost sales

2009 Qtr 1

(£000s)

2009 Qtr 2

(£000s)

2009 Qtr 3

(£000s)

2009 Qtr 4

(£000s)

Opening balance 0 19 16 (24)

Sales income: product A* 20 0 0 24

Sales income: product B 55 52 48 42

Total inflows 75 52 48 66

Raw material costs 22 22 20 17

Wages 34 33 42 40

Capital costs 0 0 26 0

Total outflows 56 55 88 57

Net cash flow 19 (3) (40) 9

Closing balance 19 16 (24) (15)


Finance

Finding the causes of a cash-flow problem: answers (1)

Possible causes:• credit given to customers of product A leading to 6 months’ delay in receiving

cash• steadily declining sales of product B, bringing in less income• significant increase in wage payments in quarter 3• large expenditure on capital costs in quarter 3


Finance

Finding the causes of a cash-flow problem: individual exercise

Find three or four possible causes of the cash-flow problem in the situation shown below.

2010 Qtr 1

(£000s)

2010 Qtr 2

(£000s)

2010 Qtr 3

(£000s)

2010 Qtr 4

(£000s)

Opening balance 0 25 10 (26)

Sales income (total inflows) 85 75 40 95

Raw material costs 27 25 25 55

Wages 33 33 27 33

Capital costs 0 0 0 0

Vehicle purchase 0 32 0 0

Loan repayment 0 0 24 0

Total outflows 60 90 76 88

Net cash flow 25 (15) (36) 7

Closing balance 25 10 (26) (19)


Finance

Finding the causes of a cash-flow problem: answers (2)

Possible causes:• seasonal sales — dramatic fall of income in quarter 3• purchase of £32,000 vehicle in quarter 2• repayment of loan — £24,000 in quarter 3• large increase in raw material costs in quarter 4 has prevented recovery


Finance

Solving cash-flow problems (1)

In groups, discuss:• possible solutions to the cash-flow problems listed on the slide ‘Finding the

causes of a cash-flow problem: group exercise’• possible solutions to the cash-flow problems listed on the slide ‘Finding the

causes of a cash-flow problem: individual exercise’


Finance


Possible answer to problems (group exercise)

Problem Possible solution

Credit given to customers of product A Debt factoring

Declining sales of product B Change marketing

Increase in wages Investigate reason

Capital costs Lease asset


Finance


Possible answer to problems (individual exercise)

Problem Possible solution

Seasonal demand Broaden product range

Purchase of asset Lease asset

Repayment of loan Spread repayment over time

Raw material costs Research other suppliers


Finance

Chapter 18

Measuring and increasing profit


Finance

Profit and profitability

profit: the difference between the income of a business and its total costs.

profit = revenue – total costs

profitability: the ability of a business to generate profit or the efficiency of a

business in generating profit.


Finance

Measure of profitability

Two ways of measuring profitability will be considered. Both measures investigate

how efficient a business is in terms of achieving a profit.

net profit margin: compares the profit made with the sales income of the

business/branch.

return on capital: compares the profit made with the amount of capital invested by

the entrepreneur or financial backer.


Finance

Net profit margin

This ratio is calculated as follows:

net profit margin (%) = net profit before tax × 100

sales income (turnover)

For example:

net profit = £20,000

sales income = £80,000

net profit margin (%) = £20,000 × 100 = 25%

£80,000


Finance

Interpreting the net profit margin (1)

To assess the meaning of a net profit margin, two comparisons are usually made:• Comparison over time. Is the net profit margin increasing (suggesting

improvements in efficiency) or decreasing (implying a decline in efficiency)?• Comparison to other firms or branches/divisions. These comparisons are

useful because they look at the business’s success (or failure) relative to other

businesses. It is much easier to make high net profit margins in some industries*

than in others; this calculation avoids judgements that may be affected by this

factor.

*These industries usually sell fewer items at higher prices, so a high net profit margin

is not a guarantee of higher overall profit levels.


Finance

Interpreting the net profit margin (2)

What conclusions can be drawn about the net profit margins of the three companies

in the table above?

Company Net profit

margin (%)

2005

Net profit

margin (%)

2006

Net profit

margin (%)

2007

Net profit

margin (%)

2008

Company A 10.3 10.9 12.0 14.0

Company B 15.2 13.8 12.4 12.1

Company C 5.6 5.5 5.8 5.6


Finance

Interpreting the net profit margin: conclusions

With all three companies, comparisons should be made with competitors in the same industry. This analysis assumes that the three companies are in direct competition.

Company A earns a consistent net profit that has increased steadily over the 4 years. In 2008, it recorded the highest net profit margin, so it is the company that appears most likely to be successful in the future.

Company B has been the most successful business for 3 of the 4 years, so its overall performance has been the best of the three companies. However, its net profit margin has fallen each year and the trend suggests that it is unlikely to be as successful as Company A in the future (unless there are specific, temporary reasons for 2007 and 2008 not being such good years).

Company C has made a consistent profit each year but it has been less profitable than the other two companies and its owners may be concerned at the relatively low levels of profit being made. However, in some competitive industries (such as supermarkets) Company C’s net profit margins are only slightly below the average.


Finance

Return on capital

This ratio is calculated as follows:

return on capital (%) = net profit × 100

capital invested

For example:

net profit = £20,000

capital invested = £100,000

return on capital (%) = £20,000 × 100 = 20%

£100,000


Finance

Interpreting the return on capital (1)

To assess the meaning of the return on capital (%), three comparisons are usually

made:• Comparison over time. Is the return on capital increasing or decreasing?• Comparison with other firms or branches/divisions. Is the money invested

in this business providing a better return than the money invested in other

businesses?• Comparison with bank interest rates. The opportunity cost for many

investments is the interest that could have been gained from placing the money

in a bank account. As there is no real risk in this investment, the return on

capital invested in a business needs to be higher than the interest rate offered

by a bank.


Finance

Interpreting the return on capital (2)

What conclusions can be drawn about the return on capital of the three companies in

the table above?

Company Return on

capital (%)

2005

Return on

capital (%)

2006

Return on

capital (%)

2007

Return on

capital (%)

2008

Company A 20.2 23.6 25.8 30.0

Company B 15.0 14.2 3.3 2.8

Company C 2.5 2.5 4.1 7.3

Bank interest

rate (%)

4.5 4.75 5.75 5.5


Finance

Interpreting the return on capital: conclusions

Company A has steadily improved and made excellent returns on capital. It is

clearly the best company in which to invest.

Company B performed well in 2005 and 2006, but its performance became

unsatisfactory in 2007 and has worsened again in 2008. Its overall return is below

the bank interest rate and it is not a good investment unless the reason for its

sudden decline can be discovered and put right.

Company C has only performed satisfactorily in one year (2008). However, it has

been improving its profitability and would seem to be a better investment for the

future than Company B.


Finance

Methods of improving profits/profitability

Many methods can be used. Three main methods are:• increasing the price• decreasing costs• increasing sales volume


Finance

Increasing the price

Increasing the price will widen the profit margin. Therefore each product sold will generate more profit.

This strategy will be particularly effective if the product is a necessity or has no close substitutes, as customers will be willing to pay the higher price.

BUT…this strategy will fail if the higher price leads to customers switching to rival products or just giving up on buying the product.

The business must analyse the likely effect of any price increase in situations where there are many close competitors.

It is possible that the price rise may cause such a large fall in demand that the higher profit margin will be offset by a dramatic fall in quantity, so the overall profit may fall.

In situations where there are many competitors, it may actually be more profitable to cut the price.


Finance

Price elasticity of demand

To assess the impact of price changes on profit, an understanding of price elasticity

of demand is needed. This is provided in Chapter 32.

After reading about price elasticity of demand, refer back to Chapter 18.

Price elasticity of demand will enable you to provide more sophisticated responses to

questions about price changes.


Finance

Decreasing variable and fixed costs

Variable costsIf the firm can cut its variable costs, the profit margin will increase.

This means that each product will yield more profit.

BUT…if the change in costs leads to a decrease in quality (e.g. inferior raw materials)

or efficiency, the demand for the product may fall.

Fixed costsProfit will also increase if fixed costs, such as rent, are reduced.

BUT…not if the cost cutting leads to lower sales (e.g. locating the shop in a place

that is less accessible to customers).


Finance

Increasing sales volume

If costs and price remain the same, it is still possible to increase profits by increasing

the volume of products sold.

A business can achieve this by a number of methods, such as:• increasing marketing• developing new products• improving quality

BUT…all of these methods will cost money.


Finance

Numerical example: background information

A business sells 500 units of a product at £10 each. Its fixed costs are £2,000 and its

variable costs are £3 per unit.

Calculate the profit made on this product.

Answer

TR – TC = £5,000 – (£2,000 + £1,500) = £5,000 – £3,500 = £1,500

Research reveals the following:

1 An increase in price to £12 will lead to a fall in sales to 450 units.

2 Cheaper raw materials will reduce variable costs to £2.50 per unit.

3 A poster campaign costing £800 will increase sales by 10%.


Finance

Numerical example: exercise

Will the changes on the previous slide increase or decrease the profit?

Taking each change in isolation, calculate the profit made from:

1 An increase in price to £12, which leads to a fall in sales to 450 units.

2 Cheaper raw materials, which reduce variable costs to £2.50 per unit.

3 A poster campaign costing £800, which increases sales by 10%.

Should the business make these three changes?


Finance

Numerical example: answers 1 and 2

1 TR = £12 × 450 TR = £5,400

FC = £2,000 TVC = £3 × 450 = £1,350 TC = £3,350

Profit = £2,050

Profit increases by £2,050 – £1,500 = £550.

Note how some of the increase in profit has come from lower variable costs because

fewer products are made.

2 TR = £5,000 FC = £2,000 TVC falls to 500 × £2.50 = £1,250

profit = TR – TC = £5,000 – (£2,000 + £1,250) = £5,000 – £3,250 = £1,750

Profit increases by £1,750 – £1,500 = £250.


Finance

Numerical example: answer 3 and conclusion

3 Sales volume increases by 10% from 500 to 550 units. FC increases by £800.

TR = 550 × £10 = £5,500 VC = 550 × £3 = £1,650

FC = £2,000 + £800 = £2,800

profit = £5,500 – £1,650 – £2,800 = £1,050

Profit increases by £1,050 – £1,500 = –£450 (the business’s profits fall by £450).

ConclusionThe business should carry out actions 1 and 2 but not implement action 3.


Finance

Extension work

Calculate the final profit if actions 1 and 2 only are implemented.

How much profit would be made if all three options were implemented?


Finance

Other methods of improving profit/profitability

Some other methods of improving profits are noted below, but this is not an

exhaustive list:• investment in fixed assets • product development • marketing • staff training

Note how each of the functional areas can contribute to improved profitability.

Can you add to this list?


Finance

Distinction between cash and profit

Profit is calculated by subtracting expenditure from revenue. It is easy to assume

that a profitable firm will be cash rich, but this is not necessarily true.

Liquidity is the ability to convert an asset into cash without loss or delay.

The most liquid asset that a business can possess is cash.

Many firms will not have their profit in the form of cash, so a high profit may not

guarantee a high level of cash.

It is also possible for a firm to have low profits but high cash levels. For example, a

business that has just borrowed a large sum of money will have high cash levels,

regardless of its profit levels.


Finance

Why a profitable firm might be short of cash

• The firm has built up its stock levels. Its wealth will lie in stocks on shelves rather

than cash. • The firm has given credit to its customers. Its wealth will be in debtors

(people who owe money to the firm).• The firm has used its profit to pay dividends to shareholders or repay long-term

loans; it may be short of cash.• The firm has purchased fixed assets, such as new machinery or vehicles.


Finance

Measuring and increasing profit: follow-up work

Complete the questions in the case study on Cadbury at the end of

Chapter 18.

Documents

Unit 2: Managing a business Finance Using budgets Chapter 16