Budgeting - HL Only Learning Objective: Explain the importance of budgeting for organizations. Calculate and interpret variances Analyse the role of budgets and variances in strategic planning. This presentation provides an overview of the key points in this chapter. Note for tutors: If you wish to print out these slides, with notes, it is recommended that, for greater clarity you select the ‘pure black and white’ option on the PowerPoint print dialogue box.

What is a Budget? Describe in your groups what you think a budget is:

Budget Defined - A detailed financial plan for the future A Budget is a target for cost or revenue that a business or department must aim to reach over a period of time. 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.

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 This slide introduces the basic ideas in relation to what constitutes a budget. A key point is the fact that several middle managers in a medium/large organisation would each be budget holders.

Types of Budget: Income Expenditure Sales Budget Production Distribution Budget Marketing Budget Material purchases Staff Budget Overheads Budget Cash Budget Master Budget

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.

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

Activity 1 Individually Analyse three problems that ‘AIS’ might have in setting up budgets for the next financial year.

Activity 2 Move into pairs Pick one problem from the group. Analyse it. (Level 5) Try to come up with a solution. (Level 6/7)

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. This slide summarises the way that budgets are produced. The main point to emphasise is that managers should have some say in their budget plan. The slide topic could be developed by suggesting what might happen to budget suggestions if sales were forecast to increase by 25% - and why.

PRODUCTION DEPARTMENT BUDGET 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 This shows a fairly simple budget plan for a production department. It is taken from the Student Handbook (page 353) and relates to a business which makes mini-scooters. The main points to highlight are that it is for one month and that it is broken down into the different areas of expenditure. The production department manager would have devised the plan based on forecast expenditure for a given level of production. He would then be responsible for keeping expenditure to the figures in the plan.

Flow diagram how to set a budget, explain each step in your own words. - pg 207 - 208

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.

The best criteria for setting budgets Incremental budgeting vs Zero Budgeting Debate!

Feedback on performance Once a budget has been set up, the following events take place: 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 This slide introduces the feedback aspect of budgets. Managers are told how much they have spent on the different items in the budget. Any major differences have to be explained and/or investigated – however, there is usually more emphasis on investigations into ‘overspends’ than ‘underspends’. This process is known as ‘control’. It allows managers to take action to solve problems.

Limitations & Benfits of budgeting Advantages Disadvantages Article in pack.

Benefits of Budget control Means of Controlling income and expenditure. Management can Hand over responsibility Ensure capital is fully employed Help coordinate business and improve communication Provide Clear targets

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.

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.

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

VARIANCES

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 Variances can be positive or negative. Negative variances are indicated by a minus sign. The use of a minus sign can be confusing, there is a better way.

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.

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.

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.

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?

Reasons for variances: Calculation errors Changes in plans External factors – fluctuations in demns Changes in interest rates Inflation

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

Is budgeting worth while? Pg 209 ‘Budget control & strategic planning’

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

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.

WHY, oh Why… does this happen???

Variance Reason? Sales variance Cost variance Materials variance Labour variance Overheads variance Profit variance Can be a Combination of the two! A price is greater/less than expected Volume is greater than or less than expected

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.

It is possible to work out the precise impact of the changes. Sales revenue variance = (AQ x AP) – (BQ x BP)

Sales revenue variance = (AQ x AP) – (BQ x BP) AP = Actual price per unit AQ = Actual Quantity sold BP = Budgeted price per unit BQ = Budgeted Quantity sold

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

Budget Control… Why bother?

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

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

Budgets and cashflow forecasts Similarities Estimated expenditure is forecast Both are broken down into monthly intervals Actual performance is compared with the plan At first glance, cashflow forecasts and budgets appear to be similar. This is highlighted above. It also provides useful revision about the key points relating to cashflow forecasts.

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 However, in other respects there are important differences. The two processes have quite different purposes. One is to check on the forecast amount of money in the bank and the other is to allocate responsibility to managers over how much money is spent.

Different types of Budgets: Historical budgeting Zero budgeting Flexible budgeting

Historical Budgeting Use last years figures Probable costs & revenue Need small increase for inflation Seen as realistic Current circumstance can differ Doesn’t take into account new aims and objectives Doesn’t encourage efficiency

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.

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

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:  

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.

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.

Flexible Budgets Budgets are kept up-to-date No set budget, no agreed targets Can use uncontrollable external factors as excuses Try to impress by reducing targets that they know they can exceed.

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