Using Budgets

What is a budget? A financial plan for the future concerning the revenues and costs of a business

Reminder from Unit 1 – a Budget… Is a financial plan Sets out financial targets Is expressed in money Contains agreed plan of action over a given period expressed in numerical terms

Budgetary control The process by which financial control is exercised within an organisation Budgets for income/revenue and expenditure are prepared in advance and then compared with actual performance to establish any variances Managers are responsible for controllable costs within their budgets and are required to take remedial action if the adverse variances are regarded as excessive

Management use budgets to… Establish priorities & set targets Turn objectives into practical reality Provide direction and co-ordination Assign responsibilities Allocate resources Communicate targets Delegate without loss of control Motivate staff Improve efficiency Forecast outcomes Monitor performance Control income and expenditure

Principles of good budgetary control Managerial responsibilities are clearly defined Managers have a responsibility to adhere to their budgets Performance is monitored against the budget Corrective action is taken if results differ significantly from the budget Unaccounted for variances are investigated Departures from budgets are permitted only after approval from senior management

Approaches to Budgeting Historical budgeting – Use last year’s figures as the basis for the budget – Realistic in that it is based on actual results – However, circumstances may have changed (e.g. new products, lost customers, credit crunch) – Does not encourage efficiency Zero budgeting – Budgeted costs & revenues are set to zero – Budget is based on new proposals for sales and costs – i.e. built from the bottom-up – Makes budgeting more complicated and time- consuming, but potentially more realistic

“Management by exception” Focusing on activities that require attention, not those that are running smoothly Budget control and analysis of variances facilitates management by exception since it highlights areas of the business which deviate from predetermined standards Items of income or spending that show no or small variances require no action. Instead concentrate on items showing a large adverse variance

Variances A variance arises when there is a difference between actual and budget figures Variances can be: – Positive/Favourable (better than expected) or – Adverse/Unfavourable ( worse than expected)

Favourable and adverse Favourable - actual figures are better than budgeted figure – costs lower than expected – revenue/profits higher than expected Adverse - actual figure worse than budget figure – costs higher than expected – revenue/profits lower than expected

Illustration of Variances ItemBudgetActualVarianceFavourable £'000 or Adverse Sales revenue Standard product759015F Premium product3025-5A Total sales revenue F Costs Wages35383A Rent15172A Marketing2014-6F Other overheads27358A Total costs971047A Profit8113F Sales of standard product are £15k higher than budget – this is a positive (favourable) variance Actual wages were £3k higher than budget – i.e. an adverse (negative) variance Overall, the profit variance was positive (favourable) – i.e. better than budget

Do variances matter? It depends on... Was it foreseen? Was it foreseeable? Size – absolute size in money terms – relative size in percentage terms Cause And whether it is a temporary problem or the result of a long term trend

What to do about a variance? Act only if the variance is outside an agreed margin – don’t waste time Investigate the cause of a significant variance Was it avoidable or unavoidable? Act to remedy the problem – if appropriate

A point to remember An adverse variance might result from something that is good that has happened in the business... e.g. higher production costs than budget (adverse variance) that occur because sales are significantly higher than budget (favourable budget)

Problems and limitations: budgets... Are only as good as the data being used Can lead to inflexibility in decision-making Need to be changed as circumstances change Take time to complete and manage Can result in short term decisions to keep within the budget rather than the right long term decision which exceeds the budget

Some behavioural implications Budgets are de-motivating if they are imposed rather than negotiated Setting unrealistic targets adds to de- motivation Budgets can contribute to departmental rivalry - battles over budget allocation Spending up to budget: it can result in a “use it or lose it” mentality - spend up to the budget to preserve it for next year

Test Your Understanding

Using Budgets