Lesson aims

• Explain the importance of budgets for organisations
• Analyse the different roles of cost centres and profit centres
• Calculate and interpret variances
• Analyse the role of budgets and variances in strategic planning

Importance of budgets for organisations

• Budget - quantitative financial plan that estimates revenue and expenditure over specified future time period.
• Budget holder - person involved in formulation and achievement of a budget.
• Planning
• Motivation
• Resource allocation
• Coordination
• Control

Cost and profit centres

• Cost centre - section of a business where costs are incurred and recorded.
• Profit centre - section of a business where both costs and revenues are identified and recorded.

Benefits

• Aiding decision making
• Better accountability
• Tracking problem areas
• Increasing motivation
• Benchmarking

Problems

• Indirect cost allocation
• External factors
• Central conflicts
• Staff stress

Variance analysis

• Variance analysis - a tool used to compare a business’ budgeted (planned) expenditure with the actual expenditure over a period of time.

Three different outcomes of variance analysis:

• Favourable variance - things were better than expected.
• Adverse variance - things turned out worse than expected.
• No variance - things turned out as planned.

Variances can occur in three different areas of a budget:

• Revenue variances
• Cost variances
• Profit variances

Example projects with budget overspend

Role of budgets and variances in strategic planning

• Strategic planning
• Control
• Measuring performance
• Motivation
• Communication
• Coordination

Advantages

• Help to control revenue and expenditure
• Provide realistic targets
• Help in coordination of various business departments
• Help to assess organisational performance
• Assist in detecting causes of any deviations in budget so that corrective measures can be taken to rectify them
• Provides objective way of appraising budget holders

Limitations

• Inflexible budgets that do not consider unforeseen changes in external environment may be difficult to stay within and therefore be unrealistic.
• Significant differences between budgeted and actual results could make budget lose importance as planning tool.
• Long-term future gains due to unexpected circumstances could be lost by looking only at current budgeted amount.
• Highly underspent budgets towards end of year could result in unjustified wasteful expenditure by managers.
• Could result in resentment and affect motivation in people not involved in setting budgets.