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

  • Businesses that use budgets are actively planning ahead

  • Problems and their solutions may be considered and solved in advance

Control

  • Frequent monitoring of budgets allows managers to precisely control their functional area

  • Budgets support the setting and review of company or department objectives

Coordination & Communication

  • Budgeting requires different parts of a business to operate as part of a coordinated whole

  • Budgets may be communicated throughout the organisation to provide a framework for decision-making and communication

Motivation & Efficiency

  • Budgets play an important role in target-setting and performance management, which can be used by managers to measure success

  • The allocation of budgets spreads decision making across the organisation, acting as a motivator to the managers who control them

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

Flowchart detailing budgeting difficulties: competition, short-term focus, time-intensive, data quality issues, influence of budget setters, motivation impacts.

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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