Budgets & Variances (DP IB Business Management)
Revision Note
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
Reason | Explanation |
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Planning & monitoring |
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Control |
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Coordination & Communication |
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Motivation & Efficiency |
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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
Historical figure budgets | Zero based budgeting |
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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
Factor | Explanation |
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Historical Data |
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Availability of Finance |
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Benchmarking |
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Negotiation |
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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
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)
Step 2 - Calculate the actual profit for 2022
£13,718 - £10,627
= £3,091 (1)
Step 3 - Subtract the budgeted profit from the actual profit for 2022
£3,091 - £4,040
= £949 (1)
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)
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
Examiner Tip
Adverse variances are not always problematic
In some cases they may reflect a reasonable business response to a change in market conditions or external factor
For example, an unexpected increase in demand may require increased output
Higher stock costs and energy use
Increased wages
Higher distribution costs
It is important to understand the context of variances before using them to support decision-making
Using Budgets & Variances in Decision-making
Budgets and variance analysis play a central role in business financial management
The Role of Budgets & Variance Analysis
Planning & Allocating Resources | Controlling & Monitoring |
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Measuring Performance | Motivation |
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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
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