Budgets (Edexcel A Level Business): Revision Note

The purpose of budgets

• A budget is a financial plan that a business (or department in the business) sets for costs and revenue

  • The budget is usually closely aligned with the business objective

Reasons for using budgets

Types of budgets

• Budgets are usually set annually and then monitored on a monthly basis

• Businesses may set budgets to monitor the financial performance of any aspect of the business

• Budgets are generally prepared using one of two methods:

  • Historical figure budgets

  • Zero-based budgeting

Historical figure budgets

• Budgets are usually based on historical data (e.g. sales and costs data from previous years) and allow for factors such as inflation and other relevant economic indicators (e.g. exchange rate variations)

Zero-based budgeting

• In some cases, businesses make the decision not to allocate budgets and use a zero-budgeting approach

  • This is particularly useful when a business needs to control costs closely (e.g. to improve profitability)

• Zero budgeting requires all spending to be justified, which means that many unnecessary costs can be eliminated

  • It can be time-consuming, as evidence to support spending decisions needs to be collected and presented

  • Zero budgeting also requires skilled and confident employees to make a persuasive case to convince those who are making purchasing decisions

Variance analysis

• A budget variance is the difference between the figure budgeted and the actual figure achieved by the end of the budgetary period (e.g. 12 months)

• Variance analysis seeks to determine the reasons for the differences between the actual figures and the budgeted figures

Favourable variances

• A favourable variance is when the actual figure achieved is better than the budgeted figure

  • A favourable variance in a revenue or profit budget is when the actual figure is higher than the budgeted figure

  • A favourable variance in a costs budget is when the actual figure is lower than the budgeted figure

Adverse variances

• An adverse variance is when the actual figure achieved is worse than the budgeted figure

  • An adverse variance in a revenue or profit budget is when the actual figure is lower than the budgeted figure

  • An adverse variance in a costs budget is when the actual figure is higher than the budgeted figure

• Once variances have been identified, a business should carefully investigate the reasons why the variances have occurred and take appropriate action, such as:

  • Where adverse cost variances are identified, a business may seek alternative suppliers or investigate ways to improve efficiency

  • Where adverse sales variances are identified, a business may review its marketing activities to improve their effectiveness

  • Where favourable cost variances are identified, a business may review key quality indicators such as the volume of returns or waste levels to ensure that output standards are being met

  • Where favourable sales variances occur, a business may reward client-facing staff with performance-based incentives

Difficulties of budgeting

• Budgeting requires significant expertise to be of genuine use to a business, and there are several difficulties associated with its construction

The main difficulties of budgeting

• Data must be up-to-date, accurate and free of bias

  • Sources of data must be selected carefully and used with care to ensure the most appropriate assumptions are made

  • Those who are constructing budgets will require skills and relevant experience to do so effectively

  • This may involve training or the recruitment of specialist staff

• Budgets can encourage managers to focus on the short-term rather than the long-term success of the business, as budgets are usually set year to year

  • Unrealistic budgets (over or under) can lead to a lack of motivation among those tasked to achieve the financial plan

• Conflict between budget holders may arise, reducing the effectiveness of the business as a whole