BUDGETS AND VARIANCES

EY
 Budgeting
The Budget Process
Limiting Factors
Motivation in the Budgetary Process
Problems and Benefits of Budgeting
Activity-Based Costing
 The Budgetary Process
Budgets are prepared for the whole business.

Budgets are normally prepared for each function or

service, or for financial and resource items such as
cash, capital expenditure, manpower and purchases.

The process of preparing and agreeing budgets is a

means of translating the overall objectives of the
organization into detailed, feasible plans of action.

The budgetary process is an integral part of both

planning and control.
 The Budgetary Process
Budgeting is about making plans for the future,
implementing them and monitoring activities to
see whether they conform to the plans.

To do this successfully requires full senior

management support, cooperative and motivated
middle managers and staff, and well organized
reporting systems.

The Budgetary Process is a continuous process,

whereby rolling budgets are prepared against
which are compared to the actual results obtained.
 Limiting Factors
A limiting factor is that factor which, at any given time,
limits the activities of an organization, such as customer
demand or production capacity.

Because such a constraint will have a pervasive effect on all

budgets, the limiting factor must be identified and its effect
on each of the budgets carefully considered.

In actual fact the limiting factor can and does change, since
when one constraint is removed, some other limitation will
occur.

Such limitations restrict the organizations operations and

restrict the actual activities.
Interrelationship of Budgets
 The Main Budgets
Sales Budget, incorporating the expected amount of sales
revenues from the different products and/or services sold.

Production Budget, showing the estimated costs of

production from labour, materials and overheads
expenses.

Capital Expenditure Budget, indicating the major capital

costs that are expected to be incurred during the budget
period, particularly the cash flows required for
investments.

Cash Budget, which illustrates the companys expected

liquidity positions throughout the budgeted period.
 Master Budgets
The Master Budgets represent the final result
of all the individual budgets, and illustrate:
The overall increase or decrease in cash and cash
equivalents.

The net profit or loss expected to be made during

the period.

The increase or decrease in owners wealth as a

result of the planned operations.
 The Cash Budget
A cash budget is one of the most important budgets
prepared in an organization because it shows the
expected cash receipts and expected cash
payments during the budget period.

The cash budget shows the effect of budgeted

activities on the cash flow of the organization.

Cash budgeting is a continuous activity with budgets

being rolled forward as time progresses. In practice,
these budgets are frequently subdivided into
reasonably short periods, normally of 1 month each.
 The Cash Budget
Cash budgets are prepared to ensure that there will be
sufficient cash in hand to cope adequately with
budgeted activities.

The cash budget may show that there is likely to be a

deficiency of cash in some future period. In such
cases, overdrafts or loans will have to be arranged or
alternative plans may have to be made.

Alternatively, the budget may show that there is likely

to be a cash surplus, in which case appropriate
investment or use for the surplus should be planned
rather than leaving this cash idle.
Reconciling Budgeted Cash and
Income Statement
There are many items which cause
differences between the two figures, but
the following are the major categories:
Sales/Purchases used in profit calculation
whereas actual receipts from debtors and
payments to creditors used in cash budgets.

Various items in cash budgets which do not

appear in profit calculations, such as capital
expenditure, taxation and dividends, increases
and decreases in loans, sales or fixed assets,
etc
Reconciling Budgeted Cash and
Income Statement
Notional cost items such as depreciation and
imputed charges appear in profit statements
but not in cash budgets.

Changes in credit policies and stock levels

affect cash budgets but not profit statements.

Accruals and prepayments are normal features

of profit statements but do not appear in cash
budgets.
 The Benefits of Budgeting
Planning and Coordination. Budgeting forces
planning to take place, and provides for the
coordination of the organizations departments in
the attainment of the overall plan.

Clarification of Authority and Responsibility.

Budgeting makes it necessary to clarify the
responsibilities of each manager who is responsible
for a budget.

Control. The process of comparing actual results with

planned results and reporting on the variations sets
a control framework which keeps expenditure within
agreed limits.
 The Benefits of Budgeting
Communication. The budgetary process is an
important avenue of communication between top and
middle management on the companys objectives.
Budgeting also communicates the agreed plans to all
staff involved to ensure that coordination is achieved.

Motivation. The involvement of budget owners in

preparing budgets and establishing clear targets
against which performance is assessed have been
found to be motivating factors.

Cash management. The integration of budgets makes

possible better cash and working capital
management.
 Problems With Budgeting
Variances are frequently due to changing circumstances
and not incorrect calculations or decisions.

Budgets are developed around existing organization

structures which may be inappropriate for current
conditions.

The existence of well documented plans may cause lack

of flexibility in adapting to change.

Badly handled budgetary systems may cause undue

pressure or lack of regard to human resources, which in
turn may lower morale.
 EXERCISE

From the information provided in Question

4, prepare the master budgets.
 Budgetary Control
The elements of Budgetary Control Systems

Variance Analysis

Reconciling Budgeted and Actual Profits

The Importance of Financial and Non-financial

Information
Elements of Budgetary Control
A budget is a statement which expresses somebodys
plans in quantitative, usually monetary, terms.

The purpose of a budget is to give a manager the

chance to determine for himself precisely how the
part of the company for which he is responsible will
perform.

Budgetary Control uses budgets as the basis for

monitoring actual performance.
 KEY ELEMENTS OF BUDGETARY
CONTROL
There must be a plan which must be capable of being
compared with what is actually happening.

Performance must be monitored as planned

performance is compared with what is actually
happening.

Variances must be reported to the responsible manager,

representing a feedback loop.

A decision must be taken by the responsible manager

with regards to the action to take.

Communication and information is essential, even when

financially things are going according to plan.
Variance Analysis
 Variance Analysis
An analysis used to compare predetermined
estimates of the costs and revenues of products and
services, and then compares these predetermined
costs and revenues with actual costs and revenues.

The predetermined costs are known as STANDARD

COSTS, and the difference between the standard
cost and actual cost is known as a VARIANCE.

The process by which the total difference between

actual cost and standard cost is broken down into its
different elements is known as VARIANCE ANALYSIS.
 Variances
A variance is the difference between the standard cost,
and the actual cost incurred.

Variances arise from differences between standard and

actual quantities and/or differences between standard
and actual prices.

Variances may be ADVERSE that is, where actual cost is

greater than standard cost; or they may be FAVOURABLE
that is, where actual cost is less than standard cost.

Variances are the starting point of any further analysis

that is carried out to determine the causes of why
budgeted and actual results have differed.
 Making Variance Analysis
Meaningful
To make variance analysis useful to management, it
is necessary to investigate the variances and the
data used to calculate them.
Is there a relationship between the variances? For
example, a favourable materials price variance
caused by the purchase of material on bulk may
be more than offset by adverse usage and labour
variances caused by poor quality material.

Can further information than merely the variance

be provided for management?
 Making Variance Analysis
Meaningful
Is the variance significant and worth reporting?
From a practical viewpoint, a variance can be
considered significant when it is of such a
magnitude that it will influence managements
actions and decisions.

Are the variances being reported quickly

enough, to the right people, in sufficient or too
much detail, with explanatory notes?
 Chart of Variances
Operating
Profit Variance

Total Sales
Total Cost
Margin
Variance
Variance

Direct Variable Fixed

Direct Wages
Materials Total Overheads Overheads
Total Variance
Variance Variance Variance

Sales Margin
Expenditure Expenditure Sales Margin
Rate Variance Price Variance Quantity
Variance Variance Price Variance
Variance

Efficiency Usage Efficiency Volume

Variance Variance Variance Variance

Capacity Efficiency Volume

Mix Variance Yield Variance Mix Variance
Variance Variance Variance
 The importance of Financial
and Non-financial information
Financial information enables the organization to
quantify options or decisions that have to be
taken.

Non-financial information is much more difficult to

gather, analyze and interpret, yet may have far-
reaching consequences on any managerial
decision to be taken.
 Financial Information
Financial information may be provided
from the following sources:
Financial Statements
Budgets
Variance Analysis and Interpretations
Interpretations of Financial Statements
Market Statistics, market share and share
prices
Other comparative financial statistics that may
be available to the organisation
 Non-Financial Information
Employees skills and knowledge

Brands strength and customers loyalty

Competitive strategies undertaken by the organisation

Access to distribution channels

Government industry regulations

Industry and Products stages in the life cycle

Suppliers and Customers switching costs

QUESTIONS