Finance - Using Budgets

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  • 1. Using Budgets
  • 2. What is a budget? A financial plan for the future concerning therevenues and costs of a business
  • 3. Reminder from Unit 1 – a Budget…• Is a financial plan• Sets out financial targets• Is expressed in money• Contains agreed plan of action over a given period expressed in numerical terms
  • 4. Budgetary control• The process by which financial control is exercised within an organisation• Budgets for income/revenue and expenditure are prepared in advance and then compared with actual performance to establish any variances• Managers are responsible for controllable costs within their budgets and are required to take remedial action if the adverse variances are regarded as excessive
  • 5. Management use budgets to…• Establish priorities & • Delegate without loss set targets of control• Turn objectives into • Motivate staff practical reality • Improve efficiency• Provide direction and • Forecast outcomes co-ordination • Monitor performance• Assign responsibilities • Control income and• Allocate resources expenditure• Communicate targets
  • 6. Principles of good budgetary control• Managerial responsibilities are clearly defined• Managers have a responsibility to adhere to their budgets• Performance is monitored against the budget• Corrective action is taken if results differ significantly from the budget• Unaccounted for variances are investigated• Departures from budgets are permitted only after approval from senior management
  • 7. Approaches to Budgeting• Historical budgeting – Use last year’s figures as the basis for the budget – Realistic in that it is based on actual results – However, circumstances may have changed (e.g. new products, lost customers, credit crunch) – Does not encourage efficiency• Zero budgeting – Budgeted costs & revenues are set to zero – Budget is based on new proposals for sales and costs – i.e. built from the bottom-up – Makes budgeting more complicated and time- consuming, but potentially more realistic
  • 8. “Management by exception”• Focusing on activities that require attention, not those that are running smoothly• Budget control and analysis of variances facilitates management by exception since it highlights areas of the business which deviate from predetermined standards• Items of income or spending that show no or small variances require no action. Instead concentrate on items showing a large adverse variance
  • 9. Variances• A variance arises when there is a difference between actual and budget figures• Variances can be: – Positive/Favourable (better than expected) or – Adverse/Unfavourable ( worse than expected)
  • 10. Favourable and adverse• Favourable - actual figures are better than budgeted figure – costs lower than expected – revenue/profits higher than expected• Adverse - actual figure worse than budget figure – costs higher than expected – revenue/profits lower than expected
  • 11. Illustration of Variances Sales of standardItem Budget Actual Variance Favourable product are £15k £000 £000 £000 or Adverse higher than budget –Sales revenue this is a positiveStandard product 75 90 15 F (favourable) variancePremium product 30 25 -5 ATotal sales revenue 105 115 10 F Actual wages were £3k higher than budget –Costs i.e. an adverse (negative) varianceWages 35 38 3 ARent 15 17 2 AMarketing 20 14 -6 FOther overheads 27 35 8 A Overall, the profitTotal costs 97 104 7 A variance was positive (favourable) – i.e. better than budgetProfit 8 11 3 F
  • 12. Do variances matter? It depends on...• Was it foreseen?• Was it foreseeable?• Size – absolute size in money terms – relative size in percentage terms• Cause• And whether it is a temporary problem or the result of a long term trend
  • 13. What to do about a variance?• Act only if the variance is outside an agreed margin – don’t waste time• Investigate the cause of a significant variance• Was it avoidable or unavoidable?• Act to remedy the problem – if appropriate
  • 14. A point to remember An adverse variance might result from something that is good that has happened in the business... e.g. higher production costs thanbudget (adverse variance) that occurbecause sales are significantly higher than budget (favourable budget)
  • 15. Problems and limitations: budgets...• Are only as good as the data being used• Can lead to inflexibility in decision-making• Need to be changed as circumstances change• Take time to complete and manage• Can result in short term decisions to keep within the budget rather than the right long term decision which exceeds the budget
  • 16. Some behavioural implications• Budgets are de-motivating if they are imposed rather than negotiated• Setting unrealistic targets adds to de- motivation• Budgets can contribute to departmental rivalry - battles over budget allocation• Spending up to budget: it can result in a “use it or lose it” mentality - spend up to the budget to preserve it for next year
  • 17. Test Your Understanding
  • 18. Using Budgets