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3.9 Budgets (HL ONLY) 2014

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Deborah Kelly

on 28 September 2017

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Transcript of 3.9 Budgets (HL ONLY) 2014

The importance of budgets for organizations
Planning -
by setting targets, managers ensure that budgets help to provide a sense of direction or purpose for organizations.

Motivation -
budget holders who are responsible for budgetary control feel empowered and trusted, which boosts their morale.

Resource allocation
- budgets help to prioritize how resources will be used in an organization.

Coordination -
budgets help to bring people from different departments together to work for a common purpose

Control -
budgets act as a monitoring and evaluation tool to check how funds are spent in each department.
is a quantitative financial plan that estimates revenue and expenditure over a specified time period. Budgets are financial targets or predictions of how much a firm is expected to spend or receive in a given time period.

Budgets help in setting targets and are aligned with the main objectives of the organization. They enable the efficient allocation of resources within the specified time period.

budget holder
is the person responsible for the formulation and achievement of a budget

Commonly used budgets are sales revenue budgets and cost budgets.
3.9 Budgeting HL
importance of budgets
cost and profit centers
strategic planning

Do you budget?

Variance Analysis
Possible Causes of Adverse Variances
Variance analysis
is the process of investigating any differences between
figures and
figures. It is essential because:
it measures differences each month and at the end of the year
it assists in analyzing the causes of deviations
an understanding of the deviations can be used to change future budgets
the performance of each budget-holding section may be appraised in an accurate and objective way
variance exists when the difference between the budgeted and actual figures leads to a
than expected profit.

variance exists when the difference between the budgeted and actual figures leads to a
than expected profit.

Managers may need to respond quickly to both adverse and favorable variances.
Sales revenue is below budget either because units sold were fewer than planned for or the selling price had to be lowered due to competition.

Actual raw material costs are higher than planned for either because output was higher than budgeted or the cost per unit of materials increased.

Labour costs are above budget either because wage rates had to be raised due to shortages of workers or the labour time taken to complete the work was longer than expected.

Overhead costs are higher than budgeted, perhaps because the annual rent rise was above forecast.
Possible causes of favorable variances
Revision Activity 1
Sales revenue is above budget either due to higher than expected economic growth or problems with one of the competitor's products.

Raw material costs are lower either because output was less than planned or the cost per unit of materials was lower than budget.

Labour costs are lower than planned for either because of lower wage rates or quicker completion of the work.

Overhead costs are lower than budgeted, perhaps because advertising rates from TV companies were reduced.
3.9 Questions + Exam Practice Question

Kraft Case Study Budgeting and Strategy
Look at the case study below and answer the questions.

Kimball Timber Ltd. Budgeted and actual figures for year ended 31 December 2010.

Sales Revenue
Direct Labour
Direct Materials
Fixed Costs
Budgeted Figures

Actual Figures

1. Calculate the budgeted profit and actual profit


2. Using variance analysis, discuss whether the management of Kimball Timber Ltd should be satisfied with the performance of the business over the last 12 months
Cost and profit centers
To be able to account for the revenues generated and costs incurred, different parts of a business are divided into
cost centers
profit centers
This is a part of section of a business where costs are incurred and recorded. Cost centers help managers to collect and use cost data effectively. Examples of costs collected in these sections include electricity, wages, advertising and insurance.
Businesses can be divided into
cost centers
in some of the following ways:

By Department
- finance, production, marketing and HR, where each department is a specific cost center.
By Product
- businesses producing several products could ensure that each product is a cost center.
By Geographical Location
- businesses that are located in different parts of the world and in each of the areas they are located could be treated as cost centers.
Profit centers
Cost centers
This is a part or section of a business where both costs and revenues are identified and recorded. These sections allow businesses to calculate how much profit each center makes. This enable comparisons to be made to judge the performance in the various sections of the business.

Profit centers too can be divided according to product, department or geographical location as long as in addition to cost revenue is also generated.
The role of cost and profit centers
Aiding decision making:
cost and profit centers help in providing managers with financial information about the different parts of a business and this information can assist them in decided whether to continue or discontinue producing a particular product.

Better accountability:
cost and profit centers help to hold specific business sections accountable.

Tracking problem areas:
can lead to a quick solution.

Increasing motivation:
Empowering and delegating control as well as bonuses or promotion for meeting targets.

Comparing the performances in the various cost and profit centers can help to check areas of most or least efficiency.
Problems of cost and profit centers
Indirect cost allocation:
indirect costs such as advertising, rent or insurance are difficult to allocate specifically to particular cost centers. They may be allocated unfairly.

External factors:
factors beyond the control of the business such as competition may affect specific cost and profit centers differently (such as higher competition in one).

Center conflicts:
staff and managers may consider the performance in their own center to be superior. This could lead to unhealthy competition between the centers.

Staff stress:
the pressure of managing a cost and profit center may be very high for some staff.
Assignment: $ in and $ out tracking for 10 days!
The role of budgets and variance
in strategic planning
Strategic planning
is an organization's systematic process of defining its future direction and deciding how to allocate its resources to fulfill this vision.

To determine its future position it first needs to know its current position and the available opportunities there are before pursuing a course of action.

This involves determining key goals or objectives stemming from the vision and putting in place a series of steps to achieve them.

Budgeting and variance analysis play an important role in strategic planning.
help to control revenue and expenditure.
provide realistic targets understood by all internal stakeholders.
help in the coordination of various business departments.

Variance analysis:
aims to compare actual performance to budgeted performance, helping to assess organizational performance.
assists it detecting the causes of any deviations in the budget so that corrective measures can be taken to rectify them.
provides an objective way of appraising budget holders responsible for their various departments.
Inflexible budgets that do not consider any unforeseen changes in the external environment may be unrealistic.
Significant differences between the budgeted and actual results could make the budget lose its importance as a planning tool.
Since most budgets are based on the short term, long term future gains such as increased sales potential due to unexpected increases in demand could be lost by looking only at the current budgeted amount.
Highly underspent budgets towards the end of the year could lead to unjustified wasteful expenditure by mangers
Setting budgets without involving some people could result in their resentment and affect their motivation levels.
Revision Activity 2
The following information refers to XAV Ltd.

Material costs
Direct labour costs
Sales of radios
Sales of Apple iPod
Advertising costs
1. Calculate the missing figures from the table above. Note whether the variance is favorable or adverse
2. Interpret the material costs variance and suggest possible reasons.
3. What do the overall variance figures tell you about the business?
Percentage Change Calculation
Further reading:
Watch short video about zero based budgeting:
Full transcript