Budgets & Variances (DP IB Business Management)

An Introduction to Budgets

• A budget is a financial plan showing the business costs and revenue for a given time period

  • Budgets are set for the whole business and for individual cost centres or profit centres

  • Budgets are set in advance (monthly, quarterly or annua) and monitored regularly

  • The budget is usually closely aligned with the business objectives
     

Why Businesses use Budgets

 
Types of budgets

• Budgets are generally prepared using one of two methods

  • Historical figure budgets

  • Zero based budgeting

A Comparison of Historical and Zero Budgeting Methods

Constructing a Budget

• The master budget consolidates all of the budgets delegated to cost centres or profit centres into one budget

• It is managed by the Finance Director
   

Diagram: common types of delegated budgets

• Sales budgets forecast the volume of sales and expected sales revenue

• Marketing budgets plan finances allocated for marketing activities including market research, promotion and pricing tactics

• Production budgets plan the level of output, stock and overhead costs as well as aspects such as waste

• Staffing budgets plan the costs involved in employing workers including recruitment and training
    

Factors affecting the construction of budgets 

• A range of factors are considered when determining budgets
   

Factors Affecting the Construction of Budgets

Understanding Budget Variances

• A budget variance is a difference between a figure budgeted and the actual figure achieved by the end of the budgetary period (e.g. twelve months)

• Variance analysis seeks to determine the reasons for the differences in the actual figures and budgeted figures
  

Diagram: to illustrate favourable and adverse budget variances

• A favourable variance (F) is where the actual figure achieved is better than the budgeted figure
  

  • A favourable variance in a revenue or profit budget is where the actual figure is higher than the budgeted figure

  • A favourable variance in a costs budget is where the actual figure is lower than the budgeted figure

  • Examples of favourable variances include

    • Actual wages less than budgeted wages

    • Actual sales volumes higher than budgeted sales volumes

    • Expenditure on raw materials less than the budgeted figure
       

• An adverse variance (A) is where the actual figure achieved is worse than the budgeted figure

  • An adverse variance in a revenue or profit budget is where the actual figure is lower than the budgeted figure

  • An adverse variance in a costs budget is where the actual figure is higher than the budgeted figure

  • Examples of adverse variances include

    • Expenditure on fuel higher than the budgeted figure

    • Profit lower than budgeted

    • Actual marketing costs higher than budgeted marketing costs

Responses to Budget Variances

• Once variances have been identified a business should carefully investigate the reasons why they have occurred and take appropriate action such as
  

  • Where adverse cost variances are identified a business may seek alternative suppliers or investigate ways to improve efficiency
    

  • Where adverse sales variances are identified a business may review its marketing activities to improve their effectiveness
    

  • Where favourable cost variances are identified a business may review key quality indicators such as the volume of returns or wastage levels to ensure that output standards are being met
    

  • Where favourable sales variances occur a business may reward customer-facing staff with performance based incentives

Using Budgets & Variances in Decision-making

• Budgets and variance analysis play a central role in business financial management
   

 The Role of Budgets & Variance Analysis

Difficulties of constructing budgets

• Budgeting requires significant expertise to be of genuine use to a business

• There are several difficulties associated with their construction

Diagram: the difficulties of budgeting

• Data must be up to date, accurate and free of bias

  • Sources of data must be selected carefully 

  • Those constructing budgets will require skills and relevant experience

• Budgets can encourage managers to focus on the short-term rather than the long-term success of the business as budgets are usually set year on year 

• Conflict between budget holders may arise, reducing the effectiveness of the business as a whole