Chapter 32

BUDGETS
32.1The Meaning and
Purpose of Budgets
 Meaning and Purpose of Budgets
detailed financial plan for the future
planning future activities by establishing performance targets
especially financial ones
No direction or purpose Unable to allocate scarce
resources of the business effectively Demotivated employees with no plans or
targets Unable to measure progress

financial needs and likely consequences

• Setting and agreeing financial targets for each section Budget set for sales,
revenue and costs
• Each cost and profit centre has a 12 month budget broken down on a month-by-month basis
 a) Measurement of Performance using
Budgets
Assess strengths
weaknesses
Take management action build on strengths and correct
weaknesses
Assess actual performance against
pre-set targets for each section
Financial Non-financial
measured against financial targets
called BUDGETS
established for all divisions and sections of a business
• Budgeting can’t measure non-financial performance indicators
 b) Benefits of Using Budgets
• Planning managers consider future plans carefully set realistic
targets help operations in producing as required marketing to sell as planned
• Effective allocation of resources Budgets help ensure businesses do not spend more resources
than it has possible to overspend confusion remains on who gets
what
• Setting targets to be achieved Targets set based on budgets of each department Motivate
managers Most motivation if they are allowed to participate in budget setting process
budget holder delegated some accountability for setting and reaching budget levels
individual responsible for initial setting and achievement of a budget
• Coordination Budgetary process requires different divisions and departments work together
and coordinate also have to work together post-budget to ensure
targets are achieved

• Monitoring and controlling a business monitor progress of budget holder and their
departments against monthly targets and annual targets
many factors may have changed since setting
budget may fail to achieve targets
• Measuring and Assessing performance
compare actual performance with original budgets
 c) Potential Drawbacks of Using Budgets
• Lack of flexibility Unexpected changes in external environment
make budgets unrealistic Demotivate budget holder and other employees
need to make budgets flexible to incorporate unexpected changes
• Focused on the short term Budgets prepared for short run Managers
may take decisions to remain within budget at the expense of long run benefits

• May lead to unnecessary spending

decide to spend unnecessarily same level of budget can be justified
next year
• Training needs must be met extensive training to set and keep budgets
• Setting budgets for new products Difficult and often inaccurate
no experience in the product
 d) Key Features of Effective Budgeting
not a forecast but a plan is a
prediction of what could occur in the future given certain conditions Budgets can
use forecasts
can be established for any part of an organization if the outcome is
measurable most cost and profit centres have budgets set

requires co-ordination between departments

should involve participation

made with the managers who will be responsible for meeting the targets
Motivates department Establishes more realistic
targets budgets for which junior
manager have been given some authority for setting and achieving
used to review the performance of each manager controlling a cost or
profit centre Appraisals carried out and communicated
useful in identifying successful and unsuccessful
managers reward and promote accordingly
 e) Variance Analysis
calculation of differences between budgets and Budgeted Actual Variance
actual figures analysis of reasons for such differences figures figures
lower Revenue 15,000 12,000 3,000 (A)
than planned profits Direct costs 5,000 4,000 1,000 (F)
Overhead costs 3,000 3,500 500 (A)
higher than planned profit
Profit 7,000 4,500 2,500 (A)

Possible causes of Adverse variances Possible causes of Favourable variances

• Revenue is below budget because
• units sold were less than planned
• selling price was lower due to competition
• Actual raw material costs are higher than planned because
• output was higher than budgeted
• cost per unit of materials increased due to inflation, shortage of
raw material or losing bulk discounts
• Labor costs are above budget because
• wage rates had to be raised due to shortages of workers; union
power
• labor time taken to complete the work was longer than
expected due to poor efficiency or using less skilled workers
• Overhead costs are higher than budgeted because of higher
administrative salaries, higher advertisement costs, higher
rents etc.
• Revenue is above budget because
• units sold were more than planned because of better products,
poor competitors’ products, economic growth
• selling price was higher due to better product, better marketing etc
• Actual raw material costs are lower than planned because
• output was less than budgeted
• cost per unit of materials decreased due to change in supplier, use
of lower quality or alternative materials or getting bulk discounts
• Labor costs are lower than planned because
• lower wage rates due to using less skilled workers or shifting
production to a low cost country
• quicker completion of the work due to greater efficiency, use of
skilled workers or higher motivation levels
• Overhead costs are lower than budgeted because of lower
advertisement costs etc.
 Benefits of Variance Analysis
• Control and Performance measurement Measures differences from planned performance
each department monthly basis at the end of the year

• Help set more realistic budgets in the future finding out reasons
can be due to poor and inaccurate budgeting

• Helps in decision making finding our reasons for variances

reduce price
• Accurate and objective appraisal of each cost and profit centre find out good and poor
performers
• Identifies potential problems Remedial actions can be taken
increasing labour productivity finding new suppliers willing
to sell at lower price
• Allows management by exception concentrate their time and efforts on major
(exceptional) problem areas
f) Setting and Using Budgets – incremental
Budgeting
uses last year’s budget as a basis
adjustment is made for the coming year
depending on market conditions
forecasted inflation expected changes in
output
only
need to justify changes or increment no fundamental appraisal of each
department’s targets or need for resources
Easy to prepare and less time consuming

Does not require justification of the whole budget Does not

allow for unforeseen events May be
increased pressure on staff
 Zero Budgeting
sets budgets to zero each year budget
holders have to argue their case for target levels

needs fundamental review of

work and importance of each budget-holding section
Changing situations can be reflected
Past errors are removed
Allows for prioritizing activities

Time consuming
 Flexible Budgeting
level of output remains at the budgeted level
Variances will not reflect real efficiency of a firm

allows cost budgets for each expense to vary if sales or production vary from
budgeted levels
actual output (figure in red in the table) budgeted standards (figures in green in the
table)
More motivating for budget holders
More realistic targets More valid and accurate variance analysis

time consuming
Fixed budget Flexible budget Actual figures Variance
Unit sales 200 250 250
Price ($) 10 10 10
Sales revenue 2,000 2,500 2,500 0
Material cost per unit 3.5 3.5 3.4
Costs of material (750) (875) (850) 25 (F) Adverse
variance based on fixed
Wages per unit 5 5 5 budget not a good
Labor costs (1,000) (1,250) (1,250) 0 reflection of performance
Gross profit 250 375 400 25 (F) output has increased
Overheads (100) (100) (150) 50 (A) favourable
Net profits 150 275 250 25 (A)
 Evaluation of Budgetary Process
• Budgets are necessary

• Budgeting process has its limitations

• Firms must undertake some form of financial planning and control

• Budgetary process can be improved by making budgets flexible and

allowing participation of junior managers in the process
• Budgets should be used with care because of its limitations
End ofChapterQuestions
Practice Questions from The Book
Practice Questions from The Book
End of chapter