Accounts & Finance

Budgeting Topic 3.4 (HL)

Introduction A budget is a financial plan for expected revenue and expenditure for an organization or a department within an organization, for a given period of time. Budgets can also be stated in terms of financial targets such as planned sales revenue , costs, cash flow or profits. A budget is prepared in advance of a period of time usually on a monthly, quarterly or annual basis.

Budgeting Estimates of the income and expenditure of a business or a part of a business over a time period: Used extensively in planning Helps establish efficient use of resources Help monitor cash flow and identify departures from plans Maintains a focus and discipline for those involved

Budgeting Types of Budgets: Flexible Budgets take account of changing business conditions. For example, flexible budgets allow production and sales budget to change according to sudden changes in the level of customer demand. Operating Budgets based on the daily operations of a business.

Types of Budgets: Production Budget – planning for the level of output over the next year including forecast for the level and cost of stocks that need to be purchased Sales Budget – focus on forecasting how many products a business aims to sell over the next year and the likely revenue to be received from these sales ie planned volume and value of sales

Types of Budgets: Marketing Budget - refers to the forecast of how a business intends to achieve its budgeted sales through marketing activities e.g. amount planned for advertising and sales promotion activities Objectives Based Budgets - Budgets driven by objectives set by the firm

Types of Budgets: Capital Budgets – Plans of the relationship between capital spending and liquidity (cash) in the business Staffing Budget – translates to monetary costs of staff that are required in the organization over the next twelve months. It will set a limit in terms of the number of staff and the overall cost of labour.

Types of Budgets: Zero Budgeting – this method sets budget holder’s account to zero per time period. The budget holder must then justify the money that they apply for i.e. there must be prior approval for any planned expenditure. Zero budgeting helps the organization to identify areas or departments that require large amount of essential capital expenditure and those that require minimal expenditure. However, it does involves a lot of management and administrative time compare to other types of budgets.

Types of Budgets: Which ever type of budget is used within an organization, these budgets are consolidated into an overall budget known as the master budget. The Chief Financial Officer (CFO) will have general control and management of the master budget including financial plans for capital expenditure on fixed assets that the firm intends to purchase over the next accounting year.

Budgeting Limitations of Budgeting: Despite the potential benefits of budgeting in helping business in its planning, coordination and control, there are numerous potential limitations of budgeting: Unforeseen changes can cause large differences between budgeted figure and the actual outcome. This can make budgets unrealistic and unachievable

Limitations of Budgeting: Tendency for budget holders to overestimate their budgets. By inflating budgets, it becomes easier to meet targets. However, an over-generous budget can cause complacency and wasteful or excessive expenditure. Budget are often not allowed to be carried forward to the following year. This means that any surplus is simply discounted in the subsequent budget. Such practice gives no incentives for budget holders to underspend.

Limitations of Budgeting: Budgets tend to be set by senior managers who have no direct involvement in the running of the department. This can cause resentment and discontent since the senior managers may not fully understand the needs of the department. Rigid and poorly allocated budgets can result in lower quality eg lower production budget may lead lower quality output due to use of substandard raw material and components.

Limitations of Budgeting: The process of planning, setting, controlling, monitoring and reviewing budgets ie setting budget or the budgeting process can be extremely time consuming. Budgeting can lead to cooperation problems within the organization as budget holders will compete to increase their own budget at the expense of their colleagues (as finances are limited).

Limitations of Budgeting: Budgeting ignores qualitative factors that affect the financial performance of an organization i.e. with budgetary control non-financial issues may be neglected such as corporate social responsibilities, responsibilities towards the natural environment, non-financial motivation of staff, customer relations management and brand development.

Limitations of Budgeting: Critics argue that the process is often too inflexible in today’s fast-paced and constantly changing business environment.

Variance Analysis Variance analysis, in budgeting (or management accounting in general), is a tool of budgetary control by evaluation of performance by means of variances between budgeted amount, planned amount or standard amount and the actual amount incurred/sold. Variance analysis can be carried for both costs and revenues.

Variance Analysis Variance: Variance = Actual - Budgeted outcome Note: the difference between planned values and actual values i.e. Variance = Actual - Budgeted outcome Note: Positive variance: actual figures above planned Negative variance: actual figures less than planned

Variance Analysis Basically two types of variances can exist Favourable variance: discrepancy is financially beneficial to the organization Unfavourable variance (or adverse variance): discrepancy is financially non-beneficial to the organization

Variance Analysis Favourable Variance: Example If the actual marketing costs were valued at $220,000 but the budgeted value was $250,000, then the firm has a favourable variance of $30,000 (-ve variance). If sales revenue were budgeted at $500,000 for a specified period of time, but the actual sales were $520,000, then there would be a favourable variance of $ 20,000 (+ve variance)

Variance Analysis Unfavourable Variance: Example If the actual marketing costs were valued at $250,000 but the budgeted value was $220,000, then the firm has a unfavourable variance of $30,000 (overspending) (+ve variance) If sales revenue were budgeted at $520,000 for a specified period of time, but the actual sales were $500,000, then there would be a unfavourable variance of $ 20,000 (underselling) (-ve variance)

Variance Analysis Question: Complete the missing figures in the ‘variance’ column and state whether the variance is adverse or favourable. Budget variances for The Wok Express Budgeted figure ($’000) Actual figure Variance Sales 500 495 Cost of sales 200 210 Gross profit 300 285 Expenses 100 90 Net profit 195

Variance Analysis Suggested Answer: Budget variances for The Wok Express Budgeted figure ($’000) Actual Variance Variance (Answer 1) (Answer 2) Sales 500 495 5 (A) 1% (A) Cost of Sales 200 210 10 (A) 5% (A) Gross profit 300 285 15 (A) 5% (A) Expenses 100 90 10 (F) 10% (F) Net profit 195 5 (A) .5% (A)

Variance Analysis Exercise: Complete the table below for Laptops–R–Us and identify variances as adverse or favourable. Variable Budget Actual Variance Sales of product A (units) 250 180 Sales of product B (units) 260 Production costs ($’000) 120 150 Output per worker (units) 20 22 Labour costs ($) 100 115

Variance Analysis Suggested Answer for Part (a): Variable Budget Actual Variance Sales of product A (units) 250 180 70 (A) Sales of product B (units) 260 10 (F) Production costs ($’000) 120 150 30 (A) Output per worker (units) 20 22 2 (F) Labour costs ($) 100 115 15(A)

Variance Analysis Variable Budget Actual Variance Sales of product A (units) 250 180 70 (A) Sales of product B (units) 260 10 (F) Production costs ($’000) 120 150 30 (A) Output per worker (units) 20 22 2 (F) Labour costs ($) 100 115 15(A) Use your answers from above to explain why variances are referred to as favourable or adverse rather than as positive or negative? -ve (A-Underselling) +ve(F-Oversell) +ve(A-Overspending) +ve (F-More Productive)

Variance Analysis: Exercise Calculate the variance, in financial terms, for each of the cases below. Show your working. Laptops-R-Us had budgeted for $6,000 operating costs in 100 machine hours. However, actual operating costs totaled $5,850 in 100 machine hours Laptops-R-Us had budgeted production of 250 units of Product A in 10 machine hours. Variable costs are $100 per machine hour. In fact, 250 units are produced in 8 machine hours.

Variance Analysis: Suggested Answer Variance for operating costs in 100 machine hours: = $5850 - $6,000 (Actual – budget) = - $150 (favourable variance, under spent) Variable costs = $100 per machine hour Budgeted, 250 units in 10 machine hours (i.e. 10 x $100 = $1,000) Actual, 250 units in 8 machine hours (i.e. 8 x $100 = $800) Variance = $800 - $1,000 = - $200 (favourable variance, under spent)

Variance Analysis Example & Interpretation Sales Variance is the difference between actual sales and planned sales. It is used to measure the performance of a sales function, and/or analyze business results to better understand market conditions.

Variance Analysis Example & Interpretation Reasons why actual sales vary from planned sales: Sales Volume Variance i.e. either the volume sold varied from plan or Sales Price Variance i.e. sales were at a different price from what was planned. Both scenarios could also simultaneously contribute to the variance.

Variance Analysis Total Variance (Sales Variance) This might have occurred where prices were lowered to increase volume, but actual volume increases did not meet expectations, perhaps due to competitors also cutting their prices, or changes in customer preferences.

Variance Analysis Example & Interpretation If the plan was to sell 5 widgets at $3 each, for a budgeted sales of (5@$3) = $15. Actual sales: 6 widgets were sold at $2 each, for an actual sales of (6@$2) = $12. The total variance was thus ($12 - $15) = $3. Unfavourable or minus $3 since total sales was less than planned.

Variance Analysis Sales Price Variance The Sales Price Variance is calculated as : Actual quantity sold × (actual selling price-planned selling price). In the example, the sales price variance was 6 × ($2-$3) = $6 (U)nfavourable or minus $6, since the sales price was less than planned.

Variance Analysis Total Variance (Sales Variance) The total variance can thus be seen algebraically to be (minus $6) plus (plus $3), giving (minus $3). Or: − 6 + 3 = − 3. This result tells us that the negative effect of selling at a lower price was twice the positive effect of selling at a higher volume than planned.

Questions: Explain the importance of budgeting for organizations. Calculate and interpret variances.