5.6. Budgets

Question 1

Define budget

Answer 1

A detailed financial plan for the future

Question 2

Purposes of budgeting

Answer 2

• Planning: makes managers consider future plans so that realistc targets can be set
• Effective allocation of resources: minimize opportunity costs
• Setting targets to be achieved
• Coordination: discussion with different departments
• Monitoring and controlling: check that objective is still within reach
• Modifying: in the case that objective cannot be reachhed
• Assessing performance: compare actual performance with original budgets through variancce analysis

Question 3

Define variance analysis

Answer 3

calculating differences between budgets and actual performance and analysing reasons for such differences

Question 4

Define delegated budgets

Answer 4

giving some delegated authority over the setting and achievement of budgets to junior managers

Question 5

Stages in preparing budgets

Answer 5

1. Establish organisational objectives which are based on
   
   • previous performance
   • external changes likely to affect the business
   • sales forecasts based on research and past sales data
2. Identify key or limiting factor that is most likely to influence the success of the business (usually sale budgets)
3. Sales budget is prepared after discussion with sales managers in all branches and divisions of the business
4. Subsidiary budgets are prepared. e.g. admnistration, labour-cost, materials-cost, selling and distribution budget (cost and profit managers should be involved)
5. Coordinate budgets to ensure consistency (may be undertaken by a budgetary committee to ensure that budgets do not conflict with each other)
6. A master budget is prepared that contains the main details of all other budgets
7. Master budget presented to the board for approval

Question 6

Define incremental budgeting

Answer 6

uses last year’s budget as a basis and an adjustment is made for the coming year

Question 7

Define zero budgeting

Answer 7

Setting budgets to zero each year and budgets holders have to argue their case to receive any finance

Question 8

What does zero budgeting mean?

Answer 8

• Starting from scratch every year
• Budget built not based on historical (past) data, but on speculation of future production necessities
• Zero budgeting would generally be fixed

Question 9

Advantages of zero budgeting

Answer 9

• Provide added incentive for managers to defend the work of their own section
• Changin situations are identified in the budget levels each year
• Forces all departments to justify their spending

Question 10

Disadvantages of zero budgeting

Answer 10

• Requires all departments and budget holders to justify their budget each year
• Time consuming
• Biased on short-term goals
• Resource-intensive

Question 11

Define flexible budgeting

Answer 11

Costs budgets for each expense are allowed to vary if sale or production vary from budgeted levels

Question 12

Advantages of flexible budgeting

Answer 12

• Show costs and revenues at various levels of activity
• May be prepared for any activity level in a relevant range
• Improve the evaluation of performance
• Reveal variance due to good or weak control
• Usage in variable cost environment
• Performance measurement (provides a good base for making comparison between actual and budgeted levels)
• Budgeting efficiency

Question 13

Disadvantages of flexible budgeting

Answer 13

• Closing delay: you must wait until a financial reporting period has been completed, then input revenue and other activity measures into the budget model, extract the results from the model, and load them into the accounting software.
• Formulation: Though the flex budget is a good tool, it can be difficult to formulate and administer. One problem with its formulation is that many costs are not fully variable, instead having a fixed cost component that must be calculated and included in the budget formula.
• No Revenue comparison: In a flexible budget, there is no comparison of budgeted to actual revenues, since the two numbers are the same.
• Applicability: Some companies have so few variable costs of any kind that there is little point in constructing a flexible budget.

Question 14

Limitations of budgeting in general

Answer 14

• Lack of flexibility: does not prepare for sudden and unexpected changes
• Focused on the short term
• May lead to unneccesary spending: might lead to surplus that was not used well enough
• Training needs must be met: managers with delegated responsibility for budgets will need extensive training

Question 15

2 types of variances

Answer 15

• Favourable: when the difference between the budgeted and actual figures leads to a higher-than-expected profit
• Adverse: when the difference between the budgeted and actual figure leads to a lower-than expected profit

Question 16

Causes of budget variances

Answer 16

• Errors:
  
  • Faulty maths/ miscalculation
  • Using assumptions that rely on inaccurate data
  • Example: the secondary research materials became outdated => false analysis of business’ performance => errors in the budget
• Changing business conditions:
  
  • Costs of raw materials
  • Labour costs
  • New competition
  • Change in fiscal/monetary policy
• Unmet expectations

Question 17

Why is variance analysis important?

Answer 17

• Helps to identify errors/inaccuracy of data
• Helps with decision making process - what measures should be taken in order to resolve adverse variance
• Management strategy required to achieve favourable variance. E.g. management by exception: the process of focusing on activities that require attention and ignoring those that appear to be running smoothly