Budgets & Variances (DP IB Business Management)

Revision Note

Flashcards
Lisa Eades

Written by: Lisa Eades

Reviewed by: Steve Vorster

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

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

  • Delegating budgets frees up time for senior managers as they do not need to authorise all financial decisions

 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

  • Budgets are usually based on prior sales and costs data 

  • They allow for external factors such as Inflation and other relevant economic indicators (e.g. exchange rate variations)

  • The most common approach to budgeting which delegates responsibility for costs and revenue generation to departments or business units

  • Budgets are not allocated at all

  • All spending must be justified 

    • Time-consuming as evidence to support spending decisions needs to be collected and presented

    • Requires skilled and confident employees to make persuasive spending/revenue generation decisions

  • Particularly useful where a business needs to control costs closely

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

The Master Budget is a consolidation of delegated budgets such as Sales, Marketing, Production and Staffing
The Master Budget is a consolidation of delegated budgets such as Sales, Marketing, Production and Staffing
  • 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

Historical Data

  • Previous years' performance determines the budget set

  • A positive economic outlook may allow budgets to be increased

Availability of Finance

  • Profitable businesses - or those able to raise finance - will be able to set more generous budgets

Benchmarking

  • Budgets are based on activities of close rivals

    • For example, marketing budgets may be increased if a close competitor increases spending on advertising

Negotiation

  • Budgets are discussed between budget holders/managers and the Financial Controller

    • There may be some rivalry between business departments/units

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

Variance analysis identifies adverse and favourable budget outcomes
Variance analysis identifies adverse and favourable budget outcomes
  • 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 Tips and Tricks

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

  • Budgets support decisions on how to allocate resources such as staff

  • Can identify need for capital investment

  • Determines under- and over-performance so reallocation of resources can be arranged

  • Budgets help to prevent overspending

  • Maintains focus on generating profit

  • Adverse variances can indicate poor manager performance 

    • Can take early steps such as training or redeployment

Measuring Performance

Motivation

  • Budgets enable the business to:

    • Judge the effectiveness of cost/revenue generation in different departments/units

    • Compare financial performance in geographical regions

    • Track financial plans over time

  • Budgets improve motivation by:

    • Rewarding effective budgetary performance

    • Providing a metric for employees to focus on

    • Increases job interest/challenge of budget holders

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

Budgets can be difficult to construct for a range of reasons
Budgets can be difficult to construct for a range of reasons
  • 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

Last updated:

You've read 0 of your 10 free revision notes

Unlock more, it's free!

Join the 100,000+ Students that ❤️ Save My Exams

the (exam) results speak for themselves:

Did this page help you?

Lisa Eades

Author: Lisa Eades

Expertise: Business Content Creator

Lisa has taught A Level, GCSE, BTEC and IBDP Business for over 20 years and is a senior Examiner for Edexcel. Lisa has been a successful Head of Department in Kent and has offered private Business tuition to students across the UK. Lisa loves to create imaginative and accessible resources which engage learners and build their passion for the subject.

Steve Vorster

Author: Steve Vorster

Expertise: Economics & Business Subject Lead

Steve has taught A Level, GCSE, IGCSE Business and Economics - as well as IBDP Economics and Business Management. He is an IBDP Examiner and IGCSE textbook author. His students regularly achieve 90-100% in their final exams. Steve has been the Assistant Head of Sixth Form for a school in Devon, and Head of Economics at the world's largest International school in Singapore. He loves to create resources which speed up student learning and are easily accessible by all.