Unit 3Accounts & Finance

Budgeting

Learning Objectives

• Understand the importance of budgeting for organisations

• Calculate and interpret variances• Analyse the role of budgets and variances in

strategic planning

What are budgets?

• A budget is a financial plan for the future. A budget forecasts future earnings and future spending, usually over a 12 month period

• Budgets attempt to consider what the future might bring. Managers must think carefully when making budgets or their predictions will be unrealistic and meaningless

• Budgets with a company will be broken down by department

• A budget will often break down the revenue and expenditure sections into many detailed categories

• Budget holders are the people responsible for generating or spending the money for each budget e.g. the budget holder of the IT Dept would be the Head of IT.

• Department budgets are broken down into budgets for specific activities • All functional budgets are added together to provide a master budget which

forecasts total expenditure.

Budgeting

• Setting budgets and establishing financial plans for the future have seven main purposes

1. Planning2. Effective allocation of resources3. Setting targets to be achieved4. Co-ordination5. Monitoring and controlling6. Modifying7. Assessing performance

What is the point of budgets?

• One of the best reasons to have a budget is so that managers can use it to monitor the business throughout the year.

• If you set planned marketing expenses at £200,000 per month, you might notice the figure going above the planned level if your marketing department was overspending. This would alert you to a problem which you might be able to solve.

• Budgets allow managers to control their spending. • The master budget helps businesses understand their cash flow situation• Budgets set targets that can be used to control or motivate staff,

depending on management style.• To allow spending power to be delegated to local managers who are in a

better position to know how best to use the organisation’s company

Example Budget

• Master Budget = £375,000• Market research £5000 • Advertising brand A £12,000 • PR budget £20,000• R&D budget £25,000 • Raw materials budget £100,000 • Marketing budget £50,000 • Wages budget £200,000 • Advertising brand B £13,000

Delegated Budgets

• Budget will be used to review the performance of a department and of the managers

• These stages of involvement in constructing the budget, taking responsibility and being appraised are crucial and play an important role in the motivation of staff

External factors

Organisational objectives

Forecasts of the future

What happened last year

Key factor – likely to be sales

Sales budget: By product by region by department

Cash budget Administration budget Materials budget Selling / distribution budget

Co-ordination essential

Master budget: Balance sheet and profit & loss account

Stages in setting budgets

• Stage 1 – organisational objectives for the coming year are established

• Stage 2 – the key or limiting factor that is most likely to influence the growth or success of the organisation must be identified (usually sales)

• Stage 3 – Sales budget is prepared• Stage 4 – Subsidiary budgets are prepared• Stage 5 – Co-ordination of budgets• Stage 6 – Master budget is prepared• Stage 7 – Master budget is presented to board of directors /

CEO

Stages in setting budgets

• Once approved, budgets will be basis of operational plans for each department

Setting budget levels

1. Incremental Budgeting – Uses last years budget as a basis and an adjustment is made for the coming year

2. Zero Budgeting – Setting budgets to zero each year and budget holders have to argue their case to receive any finance

Task

• Which industry / business would use which type of budgeting and why?

Limitations of budgeting

• Lack of flexibility• Focused on the short term• Result in unnecessary spending

Budgetary control – Variance analysis

• At the end of the budget period, the performance of the organisation needs to be compared with the original targets set and differences needs to be investigated

• The process is called Variance Analysis • Variance is the difference between budgeted

and actual figures

Variance Analysis

• It is essential because:– It measures the differences from the planned

performance of each department both month by month and at the end of the year

– Assists in analysing the deviations from budget– An understanding of the deviations can be used to

change future budgets– Appraisals for budget holders

Variances

• Adverse variance – Exists when the difference between the budgeted and actual figure leads to a lower than expected profit

• Favourable variance – Exists when the difference between the budgeted and actual figure leads to a higher than expected profit

Responding to variance analysis

• Managers may need to respond quickly to both adverse and favourable variances

Budgetary control and strategic planning

• Setting, agreeing and controlling budgets is time consuming

• Budgets can fail to reflect the changing internal and external environment causing them to be inflexible

• So then, is the budgetary process worthwhile? – Why? – Why not?