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*Accounts & Finance

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*Budgeting

*Topic 3.4 (HL)

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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.

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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

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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.

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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

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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

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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.

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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.

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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.

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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

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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.

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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.

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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).

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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.

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Limitations of Budgeting:

* Critics argue that the process is often

too inflexible in today’s fast-paced and

constantly changing business

environment.

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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.

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Variance Analysis

* Variance:

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

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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

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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)

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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)

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*Variance AnalysisQuestion:

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 ($’000)

Variance

Sales 500 495

Cost of sales 200 210

Gross profit 300 285

Expenses 100 90

Net profit 200 195

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*Variance AnalysisSuggested Answer:

Budget variances for The Wok Express

Budgeted figure ($’000)

Actual figure ($’000)

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 200

195 5 (A) .5% (A)

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*Variance AnalysisExercise: a. 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)

250 260

Production costs ($’000) 120 150

Output per worker (units)

20 22

Labour costs ($) 100 115

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*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)

250 260 10 (F)

Production costs ($’000) 120 150 30 (A)

Output per worker (units)

20 22 2 (F)

Labour costs ($) 100 115 15(A)

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*Variance Analysis

b) 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)

Variable Budget

Actual

Variance

Sales of product A (units)

250 180 70 (A)

Sales of product B (units)

250 260 10 (F)

Production costs ($’000) 120 150 30 (A)

Output per worker (units)

20 22 2 (F)

Labour costs ($) 100 115 15(A)

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Variance Analysis: Exercise

c) 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.

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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 hourBudgeted, 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)

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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.

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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.

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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.

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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.

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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.

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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.

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Questions:

1. Explain the importance of budgeting for organizations.

2. Calculate and interpret variances.