1. F INANCIAL PERFORMANCE - BUDGETS AQA Business 5 D ECISION MAKING TO IMPROVE FINANCIAL PERFORMANCE The Government sets an annual budget. What is the purpose of this? Why will businesses also set budgets?

2. 5.2.1 F INANCIAL PERFORMANCE - BUDGETS  In this topic you will learn about  Analysing financial performance  How to construct and analyse budgets  The value of budgeting  The use of data for financial decision making and planning

3. BUDGETS  Budgets are forecasts or plans for the future finances of a business  These can be for the business as a whole or set for specific functions e.g. a marketing budget  Budgets can be:  Income  Expenditure  Profit What budget would you set for a child’s birthday party?

4. BUDGETS  Income budgets  a target set for the amount of revenue to be achieved in a set time period  can be split by products, services or departments  may be translated into individual sales targets for staff  informed by market research and sales forecasts  informs predicted cash inflows in the cash flow forecast

5. BUDGETS  Expenditure budgets  a limit placed on the amount to be spent in a given period of time  can be split by department, function or product  responsibility can be passed to individual managers  a separate expenditure budget may be set for running costs and start up costs  informs predicted cash outflows in cash flow forecast  allows for monitoring of under spending as well as overspending Why have budgets been cut for UK television drams?

6. BUDGETS  Profit budgets  a target set for the surplus between income and expenditure in a given period of time  calculated based upon the income and expenditure budget  may be set for the business as a whole or for individual departments, products or branches  will be used to inform decision making on products to include in the businesses portfolio as well as were cuts may need to be made

7. T HE PROCESS OF SETTING BUDGETS Set clear objectives Carry out market research Produce a sales forecast Set expenditure budget Setincomebudget Set profit budget Set divisional targets Reviewagainstobjective

8. S AMPLE BUDGET JanFebMar Income Budget 50006000 Expenditure Budget 25003500 Profit Budgets 15002500

9. P ROBLEMS IN SETTING BUDGETS  Dependent upon predictions and forecasts  Costs are subject to change  Actions of competitors are unknown  Managers may lack experience  May be subject to bias  Take time and effort which itself has an associated opportunity cost

10. S ETTING A BUDGET - ACTIVITY  One of the biggest challenges to new businesses is developing a customer base  They need to get customers to know about their product or service yet promotional budgets are often limited  Nihal is setting up a Sri Lankan cook in sauce business offering specialist sauces to deli’s and small food outlets across the north east of England. After careful research he has estimated his income to be £100,000 and has read that on average promotional budgets tend to be between 1% and 5% of income. He is however keen to keep his expenditure budget to a minimum and has therefore decided his promotional budget should be just 2.5%  What is Nihal’s promotional budget?

11. N IHAL ’ S RESEARCH FINDINGS Promotional MethodCostPredicted resulting sales Newspaper advertisement£5003500 Food Magazine Advertisement£2002500 Brochures£2501000 Sampling£3505000 Sponsorship£1502000 Trade display stand£80010000 Business cards£1001000 When setting your promotional spending remember you might decide to have multiple purchases of one method i.e. 2 newspaper advertisements would cost you £1000. Produce a promotional budget for Nihal.

12. Variance T HE CALCULATION AND INTERPRETATION OF VARIANCES  An advantage of budgets was that they allow for monitoring of performance  This is achieved by comparing the budget to the actual  Any difference is known as a variance Profit Budget Profit Actual Expenditure Budget £25000 Variance £2000 Expenditure Actual £27000

13. T HE CALCULATION AND INTERPRETATION OF VARIANCES  Variance is therefore the difference between the actual income, expenditure or profit and the figure that had been budgeted  Variance Analysis is the process of calculating and interpreting these variances BudgetActualVariance Income£60 000£62 000£2 000 Expenditure£32 000£32 800£800 Profit£28 000£29 200£1 200

14. V ARIANCES CAN BE A DVERSE OR F AVOURABLE Adverse  An adverse variance is one that is bad for the business  Expenditure higher than budget  Income lower than budget  Profit lower than budget Favourable  A favourable variance is one that is good for the business  Expenditure lower than budget  Income higher than budget  Profit higher than budget BudgetActualVariance Income£60 000£62 000£2 000 Favourable Expenditure£32 000£32 800£ 800 Adverse Profit£28 000£29 200£1 200 Favourable

15. I NTERPRETING V ARIANCES  Once a variance has been identified it is important to  1) Identify the cause of the variance  2) Consider the effect of the variance  3) If appropriate look for a solution What are the causes, effects and possible solutions to the overspending of budgets on the HS2 project?

16. P OSSIBLE CAUSES OF VARIANCES  Action of competitors  Lower prices  Introduce a new product  Close a store  Action of suppliers  Change prices  Offer a discount  Changes in the economy  Change in interest rates  Increase to minimum wage  Internal inefficiency  Poor management of a budget  Demotivated sales team  Internal decision making  Change suppliers  Special promotions In each of these cases consider the possible impact on actual expenditure and/or Income and explain whether you think the variance will be adverse or favourable.

17. U SING VARIANCE ANALYSIS TO INFORM DECISION MAKING  Having identified variances managers now need to decide how to respond  Change budgets?  Staff training?  Reward staff?  Change suppliers?  Reallocate budgets?  New marketing tactics?  Review product portfolio? Can you think of an adverse or favourable variance where each of these might be an appropriate course of action?

18. A CTIVITY – D EL R IO P IZZERIA 6 MonthsBudgetActualVariance Pizza Sales£55 000£48 000 Drinks Sales£18 000£20 500 Materials£27 500£1 500 Favourable Drinks stock£9 000£10 250 Wages£23 000£1 000 Adverse Overheads£40 000£43 000 Profit / Loss Del Rio Pizzeria has been trading for 6 months. Toni, the owner, is worried that waste levels in the kitchen are high and customer numbers low. Fill in the gaps Identify possible causes of the variances Identify possible solutions Toni is considering lowering the materials expenditure budget for the next 6 months, discuss the arguments for and against this course of action

19. T HE VALUE OF SETTING BUDGETS  Advantages  Provides a quantifiable target against which actual outcomes can be measured e.g. Are sales targets being achieved? Are managers keeping expenditure under control? Is the businesses operating efficiently to achieve profit targets?  Informs decision making e.g. What are this year’s priorities? Where were budgets met or missed in previous years? Where can cuts be made or extra funds channelled?  Motivates budget holders due to increased responsibility With reference to any one motivational theorist explain why budget holders may be motivated by additional responsibility.

20. T HE VALUE OF SETTING BUDGETS  Disadvantages  Potential for conflict  Lack of transparency  Short term saving may be detrimental to long term objectives  May be too easy or too hard to achieve  May be restrictive  Opportunities may be missed  Inappropriate cost cuts  Time consuming to set and monitor Discuss the meaning of this quote. “ The budget evolved from a management tool into an obstacle for management.” Frank C Carlucci, American Secretary of Defence

21. 5.2.1 F INANCIAL PERFORMANCE - BUDGETS  In this topic you have learnt about  Analysing financial performance  How to construct and analyse budgets  The value of budgeting  The use of data for financial decision making and planning