Chapter 22
Unit 3.9 - Budgets(HL only)
"If you buy things you don't need, you'll soon be selling things you do."
- Filipino Proverb
Contents
3.9 Budgets (HL only)
HL content
The difference between cost and profit centre
The roles of cost and profit centres
Constructing a budget
Variances
The importance of budgets and variances in decision-making
© IBO,2022
Costand profit centres
The difference between cost and profit centres. AO2
The roles of cost and profit centres. AO2
© IBO, 2022
s a business grows in size, managing its finances
A becomes more difficult. Costs and revenues from
different areas of the business become harder to
account for. Hence, different sections of the business are divided
up into either cost centres or profit centres with a manager
being held responsible for the costs and/or revenues incurred
for each division (or centre) of the business.
A cost centre is a department or unit of a business that incurs
costs but is not involved in earning any profit. These costs are
clearly attributed to the activities of that division, such as salaries,
wages, lighting, components and capital expenditure. Making
these different sections of a business aware and accountable
for their contribution towards the organization's costs can help
managers to have better cost control. Hence, a manager will be
assigned to monitor and manage the expenditure of each cost
centre. This allows the business to see which centres are costing
the business the most money.
i
:II
Depth of teaching
§
A02 ,,•
C
A02
•s
A02,A04
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A02,A04 ~
A02
A profit centre is a department or unit of a business that incurs
both costs and revenues. Profit centres tend to be used by large
and diversified businesses that have a broad product portfolio.
Again, a manager is responsible for each profit centre, including
having to produce an independent profit and loss account.
Each profit centre is responsible for contributing to the overall
profits of the business. For example, a bank might split its profit
centres based on geographical locations. Alternatively, it might
be based on the source of revenue, such as private banking,
commercial banking, foreign exchange, mortgages, loans,
insurance and financial planning. Retailers often do this on a
branch-by-branch basis (Starbucks and McDonald's operate
profit centres in this way).
Having profit centres allows an organization to identify the
areas that generate the most (and least) revenues. Ultimately,
improved financial accountability and efficiency lead to
improved cost control and therefore higher profits for the
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 Topic 3: Finance and accounts

business. Table 22.1 outlines the various advantages and
disadvantages of cost and profit centres.
The main roles or functions of cost and profit centres are:
Organization and control function - Using cost and profit
centres enables businesses to have better financial control
over all aspects of its operations. They enable businesses to
examine and monitor costs and revenues more effectively.
Data from cost and profit centres enable managers to
compare the financial performance of the different sections
of the organization to assess its financial and operational
efficiency.
i
:II
§ Autonomy function - Budget holders of cost and profit
II
'V centres are empowered to make autonomous decisions in
C
II the best interest of their particular departments. They are
s also empowered to make autonomous decisions in a timely
fi
C manner, without the need to consult with head office,
ii: further improving operational efficiency.
Motivating function - Delegating authority to those
in charge of cost and profit centres helps to motivate
budget holders to make more informed decisions. The
business can reward managers of cost and profit centres
who meet or exceed the targets set. Similarly, by giving
departmental employees targets and rewarding them for
good performance also improves motivation.
Accountability function - The use of cost and profit centres
makes managers accountable for the performance of their
teams. They are held accountable for all costs incurred
by the cost or profit centre and their capacity to manage
these costs. Similarly, budget holders of profit centres are
accountable for the amount of costs, revenues and profit
or loss made.
Ultimately, the roles or functions of cost and profit centres
are to enable large or multi-location businesses to have better
financial management and financial performance. Used
appropriately, senior managers can use the findings from cost
and profit centres to identify high performing divisions of the
business and those which need more scrutiny. Cost and profit
centres also provide a means of measuring and assessing the
performance of employees and rewarding them accordingly.

Table 22.1 - The advantages and disadvantages of cost and profit centre

Advantages Disadvantages
Managers are forced to be more accountable for their Allocating indirect costs (such as rent, insurance and
department's contribution towards the organization's costs, administrative costs) can be a subjective task. Hence, it can be
especially as the direct costs of production can easily be difficult to accurately calculate the overheads attributable to
allocated to cost and profit centres. each cost or profit centre.
Managers can identify areas of weakness. It is not always clear The profits of a department can change simply because of
if a certain part of a business is making a loss, especially if the the apportionment of fixed costs (see Chapter 57). Allocating
organization as a whole is profitable. Using cost and profit a greater proportion of indirect costs to a particular centre
centres allows a business to identify loss-making sections or will reduce its profits, although this does not represent its
products of the business. underlying trading position.
Departments and smaller teams tend to work better than The performance of a division can change due to external
larger ones which may suffer from disorganization and a lack of factors beyond its control, such as higher raw material prices.
communication. Accountability can promote better team spirit This therefore bears no resemblance to the productivity and
and productivity within the different areas of an organization. efficiency of the individual departments of the organization.
There is no need to fuss about whether a cost is fixed, variable, Data collection is required to accurately account for all costs
indirect or direct. All costs can be allocated or spread across the and revenues of each cost or profit centre, which is likely to be
various cost and profit centres of the firm. expensive and time consuming.
Benchmarking with the most efficient cost and profit centres Managing cost and profit centres can add to the pressures
within the organization can help to improve the organization's and burdens on employees. This can lead to motivational and
overall efficiency. productivity issues.
Delegating budgeting authority to those in charge of cost and Departments are less likely to consider social responsibilities
profit centres can help to motivate these people. Delegation and ethical objectives if they are run as profit centres. This is
also helps to speed up decision-making in the organization. because compliance costs reduce their profits.
The performance of cost and profit centres can be used In an attempt to cut costs and/or raise revenues, unnecessary
to encourage and reward teams. Teams that achieve their internal competition might result. This can create tension and
targets and/or operate effectively within their budgets may be conflict between the various sections of an organization.
rewarded accordingly.

330
 3.9 Budgets (HL only)

Question 22.1

Kay Edwards is a college student who has plans to visit

Manhattan, New York, with her friends in the summer
holidays. The total cost of the vacation is expected to be
around $500. Kay has a part-time job working in a local
supermarket for which she is paid $150 per week. She
spends an average of $11O per week, although this is quite
flexible. There are ten weeks until the summer holidays.

(a) Determine whether Kay Edwards is likely to be able to

afford her overseas holiday. [4 marks]
i:,
Explain how budgeting can help Kay Edwards in her
..
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(b)
financial plans. [4 marks] ..
-a
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it

Question 22.2 - Qantas

Qantas is Australia's national flag carrier and has 65%

market share of the Australian domestic market. Qantas is
an acronym of the airline's original name, Queensland and
Northern Territory Aerial Services. It is one of the world's
oldest airlines still in operation, having been established in
November 1920. As an international carrier, it operates across
Africa, the Americas, Asia, Europe and Oceania.

Qantas's operations are varied and include cost and profit

centres that are responsible for in-flight entertainment,
food catering, members' lounges, its frequent flyer programme (customer loyalty scheme) and Codeshare Agreements (a
strategic alliance with Oneworld member airlines). It also owns Jetstar, a low-cost airline that operates both domestic and
international services. Qantas received the prestigious 'Airline of the Year' in 2021 for the Australia and Pacific region from
Skytrax, specialists in commercial air transport research and consultancy.

(a) Define the term strategic alliance. [2 marks]

(b) Explain why businesses such as Qantas use cost and profit centres. [4marks]

(c) Comment on the likely difficulties involved in allocating Qantas's overheads. [4marks]

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 Topic 3: Finance and accounts
Exam tip!
It is possible for businesses to operate both profit centres
and cost centres. For example, retailers such as Marks
& Spencer, ?-Eleven and Zara operate profit centres for
each of their outlets, but operate cost centres in their
own head office, market research teams and advertising
departments.
I
I
1
Constructing a budget (A02, A04)
• advertising, sponsorship and sales promotion.
IA
ii:
budget is a financial plan of expected revenue and
expenditure for an organization or a department
within an organization, for a given time period.
--- Budgets can also be stated in terms of financial targets such as
planned sales revenues, costs, cash flow or profits. Budgeting is
an essential part of managing business organizations. Budgets
are also needed when a business grows beyond a certain size that
prevents the owner or controller from making all expenditure
decisions.
Budgets should be set in line with the aims of the business. They
allow resources to be allocated according to the expected level of
business activity for a specified period of time, usually one year.
This frees up time for senior managers and executives as they
do not need to check and authorize all items of expenditure.
However, if a budget holder is not operating within the allocated
budget, then corrective measures can be taken to improve the
situation.
Being a forward-looking financial plan, a budget is prepared in
advance, usually on a monthly, quarterly or annual basis. The
specific purpose of a budget depends on the type of budget used
within an organization (see Box 22.1), although they all serve
to help managers plan, monitor and control business activities.
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Box 22.1 - Types of budgets
• Flexible budgets enable a business to adapt to changes
in the business environment. Rapid and sudden
unexpected changes will result in actual outcomes
being very different from budgeted outcomes.
• Incremental budgets add a certain percentage onto
the previous year's budget, usually linked to the inflation
rate, due to increased costs of production. Expenditure
items are more or less the same as before.
• Marketing budgets allow managers to plan their
marketing activities, such as the amount planned for
• Production budgets are plans for the level of output,
including forecasts for the cost of stocks that need to
be purchased. Overheads are included to help plan and
manage capacity utilization (see Chapter 40).
• Sales budgets are forecasts of the planned volume of
sales and the value of sales revenue.
• Staffing budgets are financial plans of the monetary
costs of staff over the next twelve months, such as the
number of workers and the cost of labour, including
training costs.
• Zero budgeting sets each budget holder's account to
zero. The budget holder must seek prior approval for
any planned expenditure. This helps to identify areas
or departments that require large amounts of essential
expenditure and those that require less. It also ensures
budgets do not grow organically.
In practice, whichever type of budget is used, budgets are
consolidated into the overall budget for the organization,
known as the master budget. The Chief Financial Officer
(CFO)has general control and management of the master
budget, including financial plans for capital expenditure
on noncurrent assetsthat the business intends to purchase
(see Chapter 14).
 3.9 Budgets (HL only)

Bearing in mind the purpose and importance of budgets Although there is no universally accepted template for
(covered later in this chapter), there are several considerations constructing a budget, the template in the 1B syllabus is shown
when constructing a budget. These include consideration of: below.

The availability offinance - The greater the financial strength All figures in $'000 Budgeted Actual '=
r.:
figures figures

I....
of a business, the greater the budgeted expenditure can be
Income:
allocated to each budget holder.
Salesrevenue

Historical data - Budgets are often constructed based on Interest earned

-
past trends, such as last year's budgeted figures. If economic Total income
-
forecasts are positive, then budgets may be set at a certain
percentage above last year's figures. Expenses:
Salariesand wages
..
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:,
Organizational objectives - If a business is planning external
growth, for example, then budgets need to be raised
Materials
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accordingly as both marketing and production budgets
Rent
Advertising ..
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need to be significantly higher. Electricity

Total expenses
..
8
C
C
it
Benchmarking data - Businesses often set their budgets
based on approximating the budgets of their nearest
competitors. Therefore, if Cadbury budgets for a $2 million
Net income -
Source: adapted from 1BBusiness Management Guide (2022). page 63
marketing campaign, competitors such as Nestle and Mars
are likely to follow.

Negotiations - Some budgets are set by discussions between
budget holders and the Chief Financial Officer or person in
charge of the master budget.
ATLActivity 22.1 {Thinkingskills)
With reference to the IB learner profile, discuss whether
you think it is better to be principled or open-minded
as a budget holder. Be prepared to justify your reasons.

Variances (A02, A04)

udgetary control is the use of corrective measures

B taken to ensure that actual outcomes equal the budgeted

outcomes by systematic monitoring of budgets and
investigating the reasons for any variances. A variance exists if
there is a difference between the budgeted figure and the actual
outcome. Budgetary control requires managers to investigate
the cause(s) of any variance.

Variance= Actual outcome - Budgeted outcome

Two types of variances can exist:

Favourable variances exist when the discrepancies are

Figure 22.1 - Data, such as crime rates, are used to set
budgets for police forces
financially beneficial to the organization. For example, if
actual marketing costs amount to $220,000 but the budgeted
value was $250,000, then the business has a favourable
variance of $30,000. Alternatively, if sales revenue was
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 Topic 3: Finance and accounts
budgeted at $500,000 but the actual sales were $520,000,
then there would be a favourable variance of $20,000.
Adverse variances exist when the discrepancies are
financially detrimental to the organization. They occur
when actual costs are higher than expected (i.e., there
is overspending) or when actual revenue is lower than
budgeted (i.e., there is underselling).
Budget holders need to investigate the causes of any variance.
For example, if an adverse variance is the result of overspending,
then senior managers and executives will demand an
i:II explanation. There could be valid reasons for this, such as a
8 supplier raising prices significantly after the budget had been set
,,"•c:: or because the business switched to using better-quality inputs
•s in the production process (which costs more than budgeted).
c::
•
c::
it:
Examtip!
There is no such thing as a positive or negative variance.
Mathematically, a 'positive' variance exists when the
actual outcome exceeds the planned or budgeted
outcome. However, this might not be beneficial if we
are referring to production and marketing budgets (as
it would mean incurring higher costs than planned).
Therefore, for clarity, we only talk about favourable and
adverse variances.
Variance analysis is the management process of comparing
planned and actual costs and revenues, in order to measure
and compare the degree of budgetary success. It also helps
managers to monitor and control budgets. For example, adverse
variances provide warnings of falling revenues and/or rising
costs. Managers can then implement corrective measures to
offset these unfavourable variances. Variance analysis also helps
in the review and revision of annual budgets. For example, if
there is an adverse variance in the production budget due to
rising raw material costs, more funds can then be allocated to
the production department.
Table 22.1 - Variance analysis for Sharma Visual Arts Company, for the period ended 31st March
Actual value ($)
Salesrevenue 55,000
Salariesand wages 23,000
Materials 18,000
Advertising 14,000
Rent 20,000
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Consider the data in Table 22.1 which shows the budgeted and
actual figures for Sharma Visual Arts Company. It is common
practice in variance analysis to use the abbreviations (F) for
favourable variances and (A) for adverse variances.
From the table, we can see the following:
Sales are $5,000 higher than budgeted (planned), so this is
financially beneficial to the organization. Hence, there is a
favourable variance of $5,000.
Staffing costs (salaries and wages) were budgeted at $25,000
but the business only spent $23,000 thereby saving $2,000.
Hence, there is a favourable variance.
There is an adverse variance of $3,000 for materials costs as
the company planned to spend $15,000 but actually spent
$18,000.
As there is overspending of $2,000 on the advertising
budget, this represents an adverse variance for the company.
Finally, the planned expenditure on rent matches the actual
spending on rent, so no variance exists in this instance.
Variances do not have to be expressed in monetary terms. Some
businesses prefer to use percentage figures to show discrepancies
between budgeted and actual values. For example, the sales
variance for Sharma Visual Arts Company is 10% (F) higher
than the budgeted figure ($55,000 compared to $50,000). Either
way, once variances have been calculated, managers need to
investigate the causes and to implement corrective measures.
It is common for managers to place greater emphasis on
investigating the areas with adverse variances.
Budgeted value ($) Variance
50,000 5,000 (F)
25,000 2,000 (F)
15,000 3,000 (A)
12,000 2,000 (A)
20,000 0
 3.9 Budgets (HL only)

Actual figure
($'000)
Sales revenue
Cost of sales
Gross rofit
Ex enses
Profit

Answer(1) Answer(2)

Budgeted figure Actual figure Variance Variance

($'000) ($'000) ($'000) (%)
Sales revenue 5 (A) 1%(A)
Cost of sales 10 (A) 5%(A)
Gross rofit 15 (A) 5%(A)
Ex enses 10 (F) 10% (F)
Profit 5 (A) 2.5% (A)

Question 22.3 - Laptop R Us

(a) Complete the table below for Laptops R Us and identify variances as adverse or favourable. [5 marks]

Variable Budget Actual Variance

Salesof laptop A (units) 250 180
Salesof laptop B (units) 250 260
Production costs ($'000) 120 150
Output per worker (units) 20 22
Labour costs ($'000) 100 115

(b) Use your answers from above to explain why variances are referred to as favourable or adverse variances rather than
as positive or negative variances. [4 marks]

(c) Calculate the variance, in financial terms, for each of the cases below. Show all your working.

(i) Laptops R Us had budgeted for $6,000 operating costs in 100 machine hours. However, actual operating costs
totalled $5,850 in 100 machine hours. [2 marks]

(ii) Laptops R Us had budgeted production of 250 units of Laptop A in 10 machine hours. Variable costs are $100 per
machine hour. In fact, 250 units were produced in 8 machine hours. [3 marks]

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 Topic 3: Finance and accounts

Exam tip!
Although there is not a universally accepted format for presenting budgets, for examination purposes you should stick to
the prescribed format from the 1B,which applies to both for-profit and non-profit business entities.

All figures in $'000 Budgeted figures Actual figures Variance

Income
Sales revenue 300 320 20 (F)
Interest earned 10 9 1 (A)
Total income 310 329 19 (F)

..
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:s
Expenses:
Salaries and wages 100 110 10 (A)

..
0
~ Materials
Rent
30
20
32
20
2 (A)
0
..
'a
C

~
Advertising 8 12 4 (A)

..
C
C
u:::
Electricity
Total expenses
12
170
10
184
2 (F)
14 (A)

Net income 140 145 5 (F)

Question 22.4 - Quay'sHair Salon Inc.

Dianna Quay's runs a hair salon in Florida, USA. Details of the firm's latest budget are shown below:

Variable Budgeted ($) Actual($) Variance($) Variance (F/A)

Wages 4000 4 200
Salaries 4 500 4 500
Stock 1 800 1 850
Revenue 15 750 290 Favourable
Direct costs 2 950 250 Favourable

(a) Define the term budget. [2 marks]

(b) State two examples of'stock'that are likely to be held by Quay's Hair Salon Inc. [2 marks]

(c) State two specific examples of direct costs likely to be incurred by Quay's Hair Salon Inc. [2 marks]

(d) Complete the missing figures in the table above for Quay's Hair Salon Inc. [4marks]

(e) Examine the importance of budgeting to Quay's Hair Salon Inc. [6 marks]

336

Exam tip!
Adverse variances do not necessarily represent a 'bad'
situation for a business. For example, an adverse variance
on the budgets for production costs or staff budget
might simply have been caused by an increase in output
to meet an unplanned surge in demand. it is therefore
important to look beyond just the numerical data.
Theory of Knowledge (TOK)
Is variance analysis an art or a science?
The importance of budgets and
variances in decision-making
(A02)
udgets and variance analysis are produced for four
B interrelated reasons: (i) planning and guidance, (ii)
coordination, (iii) control and (iv) motivation:
{i) Planning and guidance
Budgeting and variance analysis require managers to plan for
the future and to anticipate financial problems before they
occur. This should help organizations to be better prepared
to overcome problems should they arise. During the planning
stage of budgeting, the following questions might be asked:
How much should the business spend on marketing
activities in the forthcoming year?
How many workers are needed and how much will they
cost?
How much money should be set aside as a contingency
fund (for emergency use)?
These questions help to allocate budgets to different departments
and divisions (cost and profit centres) of the organization. They
can also help to provide some guidance for managers and
budget holders in their decision-making.
3.9 Budgets (HL only)
Figure 22.2 - Budgeting is essential aspect of financial
planning
i:,
..
§
{ii) Coordination
A budget enables managers to control the organization's ~
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money, instead of the money controlling the business. Effective ~
budgeting requires managers to match budget allocations with it
the aims of the organization. For example, the typical budget
allocated to the Science and ICT departments in a school is
understandably larger than that planned for the Psychology or
History departments.
A budget helps the entire workforce to focus on common goals.
Without proper budgetary control (any corrective measure
taken to ensure that actual performance equals the budgeted
performance), budget holders might make decisions that
conflict with those made in other departments. For example,
the marketing department might unknowingly budget sales
revenue beyond the organization's productive capacity (see
Chapter 40). Likewise, the production department might
budget to expand beyond the firm's financial means. Hence,
coordinated and controlled budgeting leads to consistent and
transparent decision-making.
{iii) Control
Just as individuals cannot continually live beyond their means
(i.e. spend more than they earn), budgeting helps to control
business expenditure. Many businesses do not have proper
or effective cost control and therefore end up overspending.
Without budgeting and variance analysis, managers are not
held accountable for their actions and expenditure. This
subsequently leads to all sorts of financial and cash flow
problems (see Chapter 20).
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 Topic 3: Finance and accounts

attention to wastage and inefficiencies, thereby possibly giving

the business a competitive advantage over its rivals. Ultimately,
budgets and variance analysis are important as they help senior
managers to make more-informed decision-making.

Despite the potential benefits of budgets and variance, there are

numerous limitations:

As with all forms of quantitative forecasts, there may be

unforeseen changes that can cause large differences between
the budgeted figures and the actual outcomes. This can
Figure 22.3 - Budgets help businesses to have better make some budgets unrealistic and targets unachievable.
i:s financial control

,,..
§ There is a natural tendency for managers to overestimate
their budgets because it becomes easier to meet their
..
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Budgets and variance analysis are used to ensure businesses targets by doing so. However, this can cause complacency

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~
have better financial control. Budget holders of cost and profit
centres are constrained by what they can do and are held
as well as wasteful or excessive spending.

accountable for their spending. Budgetary control and variance
analysis help to identify areas where a division is perhaps
overspending. Having tighter financial control can prevent a
business going into debt, particularly in large organizations that
delegate budgets to their middle and senior managers. As part
of their performance appraisal (see Chapter 10), budget holders
will discuss their budgets with the appraiser (usually the line
manager). This provides an opportunity for the budget holder
to express any areas of concern.
(iv) Motivational
According to motivational theorists such as Frederick Herzberg
(see Chapter 10), recognition, responsibility and employee
participation can motivate workers. Delegating budgetary
control to budget holders can therefore boost their level of
morale as they feel valued and trusted. Involving staff in the
budgeting process also helps to promote teamworking (a form
of non-financial motivation). This leads to further benefits such
as higher productivity and reduced absenteeism.
For businesses, budgetary control can help to allocate and
clarify responsibilities. For example, senior managers are placed
in charge oflarger budgets. It can also be linked to performance
management and staff appraisals to recognise and reward those
who achieve their performance targets.
Budgets are not always permitted to be carried forward to
the following tax year. This means that any surplus funds
do not appear in the subsequent budget. Such practice
gives little incentive for budget holders to spend within
their budgets.
Budgets can be set by senior managers who have no direct
involvement in the running of the department. This can
cause resentment and discontent as senior managers
might not fully understand the needs of the department.
Ideally, senior managers and budget holders should discuss
budgetary needs together before any funds are allocated.
Whilst budgeting is useful for businesses with stable sales
and costs, it is less useful for businesses with seasonal
fluctuations in demand and where costs are harder to
predict. This is especially the case for businesses that
source their materials from overseas (due to fluctuations
in exchange rates).
Rigid and poorly allocated budgets can harm quality. For
example, a lower production budget might lead to the use of
substandard raw materials and components. Lower quality
output will affect sales and could damage the reputation of
the business. Similarly, cutting the staffing budget can lead
to pay cuts and/or job losses, which creates poor industrial
relations (see Chapter 13).

Collectively, the four purposes of budgets and various analysis The process of planning, setting, controlling, monitoring
provide benefits that lead to the improved operational efficiency and reviewing budgets can be extremely time-consuming.
of an organization. Having to work within a realistically set
budget encourages managers to seek efficiency gains by drawing
338

As finances are limited, one department's gain is another's
loss. Budget holders compete to increase their own budgets,
at the expense of their colleagues responsible for other cost
or profit centres. Hence, budgeting can cause conflict in the
workplace and perceptions of inequity (unfairness).
Budgeting and various analysis ignores qualitative factors
that affect the financial performance of an organization,
such as corporate social responsibilities (see Chapter 3),
non-financial motivation of staff (see Chapter 10), brand
development (see Chapter 27) and responsibilities towards
the natural environment (see Chapter 46).
The budgeting process is rather inflexible in today's fast-
paced and constantly changing business environment.
Hence, budgeting can be of limited use as a management
tool.
Key concept
Does the budgeting process allow for imagination and
creativity?
Budgets and the key concepts
Budgeting helps to ensure that managers plan ahead by
anticipating the costs and revenues of different business
activities in a changing environment. It also involves managers
agreeing on priorities and targets. Hence, budgeting has a
central role in strategic planning and decision-making to
ensure businesses can operate in a sustainable way. Budgeting
as an ongoing process is summarised in Figure 22.4.
Planning Setting
Controlling
Reviewing
Monitoring
Figure 22.4 - The budgeting process
3.9 Budgets (HL only)
Since budgets are financial plans used to achieve the strategic
goals of the organization in a changing business environment,
SMART budgeting requires budgets to be:
Specific - Budgets should be set in line with the strategic
vision of the organization.
Measurable - Any budgeting system should ensure that
budget holders are held accountable for their successes or
shortcomings. Variance analysis can help in this process.
Agreed - For budgeting to work properly, budgets should '!
be set through a process of negotiations and discussions to ~
ensure that appropriate budgets are set. §
•
'V
C
Realistic - Only realistically set budgets can motivate people
to reach the set targets. Under-funding will hinder output,
•s
C
whilst over-funding is likely to lead to complacency, C •
ii:
inefficiencies and wastage.
Timed constrained - Since budgets are financial plans for
the foreseeable future, there must be a set time constraint.
Some businesses allow budget holders to carry forward
any unspent funds, whilst other organizations do not
encourage this.
During times of change, budgets need to be adjusted to account
for strategic and tactical changes. However, unless budgets are
changed accordingly, the plans and targets become unrealistic
or irrelevant. For instance, if the budgeting process is too rigid,
the business will not be in a position to respond to changes in
the external environment (see Chapter 46).
Creativity could be hampered if managers become unwilling to
take risks that could lead to adverse variances in their budgets.
However, creativity can be integral to any growth strategy.
Not only are financial plans needed to fund the creativity and
growth, but the budgeting process also enables a business to
have better cost control as it grows, because costs will clearly
increase.
However, budgeting does not come without its problems.
For example, sales forecasting (see Chapter 25), which is a
prerequisite to setting the sales budget, is only as accurate as
the quality of the data used to make the predictions.
Nevertheless, used ethically and correctly, budgets can motivate
and empower budget holders, foster responsibility and
accountability and aid financial control. Ultimately, effective
budgeting avoids inefficient expenditure, thus helping to
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 Topic 3: Finance and accounts

enhance the organization's competitive strength and improving 6. What are the main considerations when setting budgets?
its sustainability as an organization.
7. What is budgetary control and why is it important to an
organization?
Business
ManagementToolkit
8. What is variance analysis and why is it an important
Discusshow organizationalculture(seeChapter11) management tool?
andculturaldimensions(seeChapter54)canInfluence
the roleof budgetsand varianceanalysisIn business 9. How do favourable variances differ from adverse variances?
organizations.
10. What are the main limitations of budgeting?

i
:II
§ Key concept
II
'V KEYTERMS
C
II With reference to an organization of your choice, discuss
s how budgeting influences change and sustainability. Adverse variances are discrepancies between actual outcomes
fi
C and budgeted outcomes that are detrimental to an organization,
ii: such as production costs being higher than expected.

A budget is a financial plan of expected revenue and expenditure

Key concept for a department or an organization, for a given period of time.

Enron was once the seventh largest American company
and had been voted by Fortune magazine as the
'most innovative company' for six consecutive years.
However, in 2001, the company went bankrupt due to
accounting fraud, which left its investors and 20,600
employees with absolutely nothing.
Discuss the role of ethics in the budgeting process.
Budgetary control refers to the use of corrective measures taken
to ensure that actual outcomes equal the budgeted outcomes, by
systematic monitoring of budgets and investigating the reasons
for any variances.
A cost centre is a department or division of a business that
incurs costs that are clearly attributed to the activities of that
unit of the organization.

Favourable variances are discrepancies between actual

outcomes and budgeted outcomes that benefit an organization,
such as sales revenues being higher than expected.

A profit centre is a department or divisionof a business that

REVIEWQUESTIONS incurs both costs and revenues. Profit centres tend to be used
by large and diversified firms that have a broad product range.
1. What is a cost centre?
Variance refers to any discrepancy between actual outcomes
2. What is a profit centre? and budgeted outcomes.

3. What are the main roles (functions) of cost and profit Variance analysis is the management process of comparing
centres? planned and actual costs and revenues, in order to measure and
compare the degree of budgetary success. It also helps managers
4. What are the main advantages and disadvantages of using to monitor and control budgets.
cost and profit centres?

5. What is meant by a budget?

340