3.9. Budgets (HL only)

  • Budgets
    • Target for costs or revenue that a firm or department must aim to reach over a given period of time
  • Importance of budgets for organizations
    • To ensure spending is within the set expectation
    • To provide a yardstick against a manager’s success or failure
    • To enable spending power to be delegated to the local managers to know how best to use the firm’s money
    • Purpose
      • Planning and guidance
      • Coordination
      • Control
      • Motivation
    • Advantages
      • Controls or monitors costs
      • Gives an overall picture for the firm
      • Vital too when coordinating a firm’s diverse activities
      • Motivational effect – they feel trusted and allied
    • Limitations
      • Not an exact tool
      • Budgets can be overestimated so it can be easily be met by managers (may cause complacency or wastefulness)
      • Managers may manipulate the budget so their department can get more funds than needed
      • Managers who may not be involved in the department may be the ones who set the budget
      • Competition over budgets
  • Cost centers
    • Department or unit of business that incurs costs
    • Doesn’t contribute to profit directly.
      • e.g. Marketing and HR departments
    • Departments must be made aware of their costs to help managers operate within the allocated budget
    • Cost centers have to keep their costs below the budgeted/predicted value.
  • Profit centers
    • Branch of a company that is accounted for on a standalone basis for the purposes of profit calculation
    • Similar to revenue streams – sources of revenue/potential profit for a business
    • Used to know which aspects of a business are the most and least profitable
    • Managers have to be responsible for costs and earnings of their profit center, and they should know how to best use resources to maximize profitability
  • Variances
    • The amount by which the actual result differs from the budgeted figure
    • Usually measured each month by comparing the actual figure with the budget
    • Value of regular variance statements
      • Provides an early warning; identifying symptoms
    • Types of Variances:
      • Favorable Variance
      • Adverse Variance
      • (Not positive or negative. A bigger actual figure for production costs would be adverse, while a bigger actual figure for sales revenue would be favorable.)
    • Management by exception (For large corporation)
      • In order to avoid information overload, senior managers will concern themselves with departmental budgets which show large variances
  • Role of budgets and variances in strategic planning
    • Budgeting helps to ensure that managers plan ahead by anticipating the costs and revenues of different business activities
    • Budget control encourages regular monitoring and review of budgets to deal with any variances
    • Requires managers to investigate causes of any variance from budgets
    • Ultimately, effective budgeting avoids inefficient expenditure, and enhances a company’s competitive strength and strategic direction

 

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