Budgets (Edexcel A Level Business)
Revision Note
The Purpose of Budgets
A budget is a financial plan that a business (or department in the business) sets about costs and revenue
The budget is usually closely aligned with the business objective
Reasons for Using Budgets
Reason | Explanation |
---|---|
Planning & monitoring |
|
Control |
|
Coordination & Communication |
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Motivation & Efficiency |
|
Types of Budgets
Budgets are usually set annually and then monitored on a monthly basis
Businesses may set budgets to monitor the financial performance of any aspect of the business
Budgets are generally prepared using one of two methods
Historical figure budgets
Zero based budgeting
Historical figure budgets
Budgets are usually based on historical data (e.g. sales and costs data from previous years) and allow for factors such as Inflation and other relevant economic indicators (e.g. exchange rate variations)
Zero based budgeting
In some cases, businesses make the decision not to allocate budgets and use a zero budgeting approach
This is particularly useful where a business needs to control costs closely (e.g. to improve profitability)
Zero budgeting requires all spending to be justified, which means that many unnecessary costs can be eliminated
It can be time-consuming as evidence to support spending decisions needs to be collected and presented
Zero budgeting also requires skilled and confident employees to make a persuasive case to convince those making purchasing decisions
Variance Analysis
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
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
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
Worked Example
Selected financial information for Bunsens PLC 2022
| £m |
Budgeted sales revenue | 12,460 |
Actual sales revenue | 13,718 |
Budgeted total costs | 8,420 |
Actual total costs | 10,627 |
Using the data, calculate the total profit variance for Bunsen PLC in 2022. You are advised to show your working (4)
Step 1 - Calculate the budgeted profit for 2022
£12,460 - £8,420
= £ 4,040 (1 mark)
Step 2 - Calculate the actual profit for 2022
£13,718 - £10,627
= £3,091 (1 mark)
Step 3 - Subtract the budgeted profit from the actual profit for 2022
£3,091 - £4,040
= £949 (1 mark)
Step 4 - Identify the nature of the variance
In this case, the variance is adverse because the actual profit for 2022 is lower than the budgeted profit for 2022
The correct answer is £949 A (1 mark)
Examiner Tip
Although the Bunsen Plc example shows an adverse profit variance, it is worth noting that the company’s actual sales revenue was higher than budgeted. There could be some sales executives in the business that deserve some sincere congratulation!
You may recommend that the business should investigate the reasons for the adverse profit variance. The focus of the examination must be on the higher than budgeted costs rather than this seemingly positive sales performance. You may recommend that Bunsen reviews its supply agreements or that it adopts a zero budgeting approach.
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 waste levels to ensure that output standards are being met
Where favourable sales variances occur, a business may reward client-facing staff with performance based incentives
Difficulties of Budgeting
Budgeting requires significant expertise to be of genuine use to a business and there are several difficulties associated with their construction
The difficulties of budgeting
Data must be up-to-date, accurate and free of bias
Sources of data must be selected carefully and used with care to ensure the most appropriate assumptions are made
Those constructing budgets will require skills and relevant experience to do so effectively
This may involve training or the recruitment of specialist staff
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
Unrealistic budgets (over or under) can lead to a lack of motivation amongst those tasked to achieve the financial plan
The conflict between budget holders may arise, reducing the effectiveness of the business as a whole
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