2-2-4-budgets

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