3.9. Budgets (HL only)

Syllabus Content

  • The importance of budgets for organizations
  • The difference between cost and profit centres
  • The roles of cost and profit centres
  • Variances
  • The role of budgets and variances in strategic planning

Triple A Learning - Budgets

The importance of budgets for organizations

In the most basic sense, a budget tries to predict the inflow and outflows that a company will incur. This can be drilled down by division and within each department and put all back together to make a master budget. These budgets are typically created on a monthly, quarterly or annual basis but with the use of technology some companies are going to real time budgets (especially for sales).

Why make a budget?

Budgeting is much more about strategy rather than only looking costs and revenues. If a firm aims to achieve certain objectives, it is necessary to know whether or not it has the necessary capital to achieve them. If not, then the strategy may need to be scaled back, pricing policies may need to change, additional sources of finance may be needed or investment decisions may be altered. Only with a proper budget can a firm turns its strategy into practice.

Organisations produce budgets for a variety of reasons including:

● To motivate managers by giving them goals

● To co-ordinate business activities

● To help foresee potential problems

● To formalise business plans and objectives

● To have a basis on which to make comparisons with actual results

By breaking down budgets by division, firms can see whether each division is meeting its benchmarks and also how each division contributes to the firm. This can then be broken down regionally to see how division differ over different regions.

Some of the most common budgets made include:

● Sales revenue budget

● Marketing budget

● Capital expenditure budget

● Cash flow budget

By comparing the above, a firm will be able to see whether they are allocating their resources correctly and if the allocation reflects the strategy of the company. To make a budget one must look at past final accounts in order to predict the future and also external forces which may affect the future. Let's look at the following as an example.

Prediction

Once a prediction of sales is made, are they in line with the firm’s goals and objectives? Does the marketing budget need to be increased? Can we now predict our costs? Do we need to invest in more capital? Now think if we used the same sales information and then broke it down country or even city. Would that information help us in our budgeting and planning process?

By comparing the results across divisions one can see a variety of characteristics such as:

● Is the firm’s strategy actually working?

● Which division/department are using capital most effectively?

● Are divisions/departments meeting the targets and benchmarks initially set?

● How effectively are divisions at controlling costs? Is it a corporate problem or can it be drilled down to certain divisions?

● Are the staff within specific divisions motivated and productive?

● How can staff receive incentives based on the financial performance of themselves and their department?

● If meeting targets, can departments be given more autonomy to control their own budget.

● How do divisions and managers handle exceptions, especially negative variance.

● Are departments having a silo effect where there is a lack of communication and common goal between departments.

Going through the process of making a budget is a good exercise for any department. By looking back at the final accounts, the firm is forced to reflect on the past and find way they can improve and be more in line with the firms objectives. These departmental budgets can then be consolidated into a master budget in order to see the big picture of the firm. The master budget gives the Chief Financial Officer the necessary snapshot of the firm in order to see what capital expenditures the firm may undertake. Firms can also compare themselves with other public firms to see where they stand with their competition.

Source - http://www.dpbusinessmanagement.com/34-budgeting.html

Task 1: Design an incremental budget for Orion Ltd.

Orion Ltd plans to sell 50000 units in the forthcoming year. The selling price is estimated at $30 per unit. The unit cost comprises the following

Direct Costs

● Direct Materials 1 unit at $2.50

● Direct labour 4 hours at $2.00 per hour per unit = $8

● Direct Expenses $3 per unit

Indirect Costs

● Administration Costs $220,000

● Distribution Costs $60,000

● Marketing Costs $300,000

Taxation is 30% of pre-tax profits.

There is no interest payable or receivable.

Difference between cost and profit centres

Types of responsibility centres

1. Cost centres: a cost (expense) centre is one in which the manager’s responsibility is limited to control of costs. The performance report will show the controllable costs of operating the unit for a specified time period. The costs for which the manager has direct responsibility will appear in the performance report of that unit. The manager of a cost centre is evaluated on the basis of his or her ability to accomplish assigned tasks at an acceptable cost. The amount of costs considered acceptable is often determined by reference to the costs of previous periods. The acceptable level of costs may also be established by an evaluation of what the costs should be to accomplish the task. This approach is considered more desirable.

2. Revenue centres: Organisational sub-units whose activities are primarily related to making sales may be viewed as revenue centres. In this case, performance is evaluated in terms of revenues achieved and direct costs incurred, usually compared with either predetermined or historical revenues and cost amounts.

3. Profit centres: if a segment of the organisation has profit responsibility it can be treated as a profit centre. The focus of control in this situation shifts from a detailed analysis of revenues and expenses to the evaluation of profits. If the organisation is highly decentralised, profit centre managers are considered to be responsible for the total operation of their units. However, there is not always a direct relationship between the use of the term profit centre and the extent of decentralisation of decision-making. Horngren and Foster (1991) point out that it is possible that a highly centralised organisation may describe some of its sub-units as profit centres but because of the high levels of centralisation, profit centre managers actually have little or no authority.

These profit centres are often referred to as strategic business units (SBUs)

Horngren, T and Foster, G. (1991) Cost Accounting: A Managerial Emphasis, Prentice Hall, Englewood Cliffs

Spillinglaw, G. (1982) Management Cost Accounting, 5th edition, Richard Irwin, Homewood

Cost Centres and Profit centres

‘Variance Analysis

A key word to understand when you are looking at budgets is “variance”

A variance arises when there is a difference between actual and budget figures

Variances can be either:

● Positive/favourable (better than expected) or

● Adverse/unfavourable (worse than expected)

A positive/favourable variance might mean that:

● Costs were lower than expected in the budget, or

● Revenue/profits were higher than expected

By contrast, an adverse/unfavourable variance might arise because:

● Costs were higher than expected

● Revenue/profits were lower than expected

Should variances be a matter of concern to management? After all, a budget is just an estimate of what is going to happen rather than reality. The answer is – it depends.

The significance of a variance will depend on factors such as:

● Whether it is positive or negative – adverse variances (negative) should be of more concern

● Was it foreseen?

● Was it foreseeable?

● How big was the variance - absolute size (in money terms) and relative size (in percentage terms)?

● The cause

● Whether it is a temporary problem or the result of a long term trend

“Management by exception” is the name given to the process of focusing on activities that require attention and ignoring those that appear to be running smoothly.

Budget control and analysis of variances facilitates management by exception since it highlights areas of business performance, which are not in line with expectations.

Items of income or spending that show no or small variances require no action. Instead concentrate on items showing a large adverse variance.

Are all adverse variances bad news?

Here is a point that students often find hard to understand – or believe!

An adverse variance might result from something that is good that has happened in the business.

For example, a budget statement might show higher production costs than budget (adverse variance). However, these may have occurred because sales are significantly higher than budget (favourable budget).

Remember, it is the cause and significance of a variance that matters – not whether it is favourable or adverse.

Variances illustrated

Task 2: Consider the following budget statement and calculate the variances

What do the numbers in the budget statement tell us?

Looking at the sales revenue section, you can see that actual sales of standard product were £15k higher than budget – this is a positive (favourable) variance.

Turning to the costs section, actual wages were £3k higher than budget – i.e. an adverse (negative) variance.

Overall, the profit variance was positive (favourable) – i.e. better than budget.’

Source: http://www.tutor2u.net/business/accounts/variance-analysis.html [accessed Sunday 22nd March, 2015]

Calculating Budget Variances

Variance analysis

The role of budgets and variances in strategic planning

A budget is a plan of the relevant costs and revenues in order to achieve the objectives of an organization in the coming financial year. Most businesses prepare a budget to include all their activities, based on a predicted level of sales. There are both positive and negative attributes of budgeting.

Positives of Budgeting

  • They are a basis for control and clearly lay out objectives related to the budget
  • Provide a basis for measuring success or failure with the use of variance analysis – the management can see if targets are being adhered to and take corrective action if they are not
  • They encourage co-ordination and communication between departments
  • They ensure that the financial implications of business activities are fully considered
  • They provide a simple tool for all employees and provide an incentive for action, especially if there are financial rewards linked to the attainment of financial targets
  • They provide an opportunity for ‘management by exception’ – allowing management to concentrate on core business issues and to take action only when significant variances occur.

Negatives of Budgeting

  • Budgeting can be very expensive (need to hire accountants or financial advisers) and difficult for small firms to do well.
  • Budgeting focuses on the financial aspects of the firm but managers need to be aware of other areas such as motivation of employees and customer satisfaction. In addition, failure to meet budget requirements may be a de-motivator to staff especially if the failure is outside of their control. Linking incentives to rigid budgets may be counter-productive.
  • A budget encourages departments to spend all amount budgeted even if not required because of fear that next year they may not receive as much money in their budget if they don't spend it all this year. Budgets may be related to more to power and status than to the requirements of the business. Departments may inflate budgets to ensure that their position in the business is enhanced.
  • Setting realistic budgets may be difficult in dynamic markets. Recent business theorists have argued that rigid budgets in these circumstances are a waste of time and resources.
  • Budgets are only as good as the data used to prepare them. If sales revenue are unpredictable then the preparation of budgets related to these may be worthless.

Task 3: Wrong Ltd had originally set out its master budget for 2013 based on an expected volume of 100000 units as follows (sales and production were planned to be 100000 units).

At the end of 2013, however, it was revealed that Wrong Ltd had understated its volume of output by 50% when compared to the actual volume.

You are required to prepare a flexible budget, which the management of Wrong Ltd can use to evaluate the actual performance of the enterprise in the area of cost control.

(a) Classify the above costs into fixed and variable costs. Give reasons for your choice

(b) Calculate the cost per unit for direct materials and direct wages

(c) Prepare a flexible budget for 90% (output level) = 9000

(a) Separate production overheads and other overheads into fixed and variable elements

(b) Prepare a flexible budget for a 90% activity level (output level = 18000)

Files to download

3.9. Budgeting .docx