Using Budgets Effectively (Cambridge International A-Level Business)

An introduction to budgets

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

  • The budget is usually closely aligned with the business objectives

Budgets can be used to compare overall business performance and compare functional performance over time

Measuring performance with budgets

Measuring overall business performance

• Budgets allow managers to assess how well the whole business is performing

  • Compare actual income and expenses with budgeted figures to identify profit levels, cost control, or overspending
  • Helps judge if the business is meeting its financial goals, such as revenue targets or profit margins
  • Variances *help explain good or poor performance

Measuring functional performance

• Each function, e.g. marketing, operations, HR, usually has its own budget

  • Comparing actual department spending and results with the budget shows how well each area is performing
  • Helps hold managers accountable for cost control and meeting targets
  • Encourages efficient use of resources within each function

Comparing performance over time

• Budgets help track performance year-on-year or month-on-month
• Businesses can spot trends, such as rising costs or improving efficiency
• Helps with long-term planning and forecasting

Comparing performance across functions

• Budgets help compare different departments at the same time, even if their roles are different
• This supports fair decision-making on things like bonuses, promotions or extra funding

Types of budgets

1. Incremental budgets

• An incremental budget is based on last year’s figures, with small adjustments made to reflect expected changes

  • Changes could include inflation, wage rises or modest increases in sales and costs

Evaluating the use of incremental budgets

2. Flexible budgets

• A flexible budget is adjusted depending on the level of output or sales

  • Instead of using one fixed figure, it shows what income and expenses should look like at different levels of activity

Evaluating the use of flexible budgets

3. Zero budgeting

• Zero budgeting is when every department or manager must justify all spending

  • Rather than using the previous year’s budget as a starting point, each cost must be reviewed and approved individually

Evaluating the use of zero budgeting

The use of budgets

• Budgets can play an important role in the day-to-day management of a business
• They help with planning, decision-making, control, and monitoring of non-financial performance

Ways budgets are used

Allocating resources

• Budgets help businesses decide where money and resources should be focused
• Each department receives funding based on its needs and priorities, ensuring efficient use

Control within a business

• Budgets set clear financial limits to help prevent overspending
• Managers are accountable for staying within their budget, which improves discipline and control

Monitoring non-financial performance

• Budgets can track spending on non-financial goals like customer service, training, or sustainability
• This ensures resources support wider business objectives

Variances

• Once budgets have been set, managers carry out variance analysis to compare actual performance to the targets set in the budget

  • A budget variance is a difference between the figure budgeted and the actual figure achieved by the end of the budgetary period

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

Types of variance

Calculating and interpreting variances

• A budget variance is calculated by subtracting the budgeted figure from the actual figure

$\mathrm{Revenue} \mathrm{variance}=\mathrm{Actual} \mathrm{revenue}-\mathrm{Budgeted} \mathrm{revenue}$

$\mathrm{Cost} \mathrm{variance}=\mathrm{Actual} \mathrm{cost}-\mathrm{Budgeted} \mathrm{cost}$

$\mathrm{Profit} \mathrm{variance}=\mathrm{Actual} \mathrm{profit}-\mathrm{Budgeted} \mathrm{profit}$

Worked Example Selected financial information for Barwicks PLC (2024)

	£m
Budgeted sales revenue	12,460
Actual sales revenue	13,718
Budgeted total costs	8,420
Actual total costs	10,627

Using the data, calculate the total profit variance for Barwicks PLC in 2024. You are advised to show your working.

(4)

Step 1: Calculate budgeted profit for 2024

equals space £ 12 comma 460 space minus space £ 8 comma 420

equals space £ 4 comma 040 **(1)

Step 2: Calculate actual profit for 2024

equals space £ 13 comma 718 space minus space £ 10 comma 627

equals space £ 3 comma 091** (1)

Step 3: Subtract budgeted profit from the actual profit for 2024

equals space £ 3 comma 091 space minus space £ 4 comma 040

equals space minus £ 949 space **(1)

Step 4: Identify the nature of the variance

• In this case, the variance is **adverse **because the actual profit for 2024 is lower than the budgeted profit for the year
• The correct answer is** £949 A**** (1)

Evaluating budgets

• Budgets can be useful management tools because they help maintain financial control by monitoring income and expenditure

  • This allows managers to spot potential overspending or cash flow problems early

• Budgets also help measure performance by setting financial targets that can be compared with actual results

  • This makes it easier to assess how well a department or the whole business is performing and whether corrective action is needed.

• However, budgets are based on forecasts and assumptions, which means managers make inappropriate decisions if market conditions change or if estimates are wrong

• Strict budgets may reduce flexibility

  • Managers may feel restricted and unable to respond quickly to unexpected opportunities or urgent problems if they are required to stick closely to a fixed spending plan

Advantages and disadvantages of budgeting