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IB Business & Management Budgets & Variances

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1. Set the budget period (a year, a month, etc)

2. Co-ordinate with the overall strategy

3. Gather information from: 3 (b) Forecast of future

results

3 (a) Past results

4. PRODUCE THE DIFFERENT BUDGETS

Co-ordinate together to:

5. PRODUCE THE MASTER BUDGET

Budgets Definition of a budget: an agreed, co-ordinated financial plan to enable all parts of the business achieve its objectives over a specified period of time. Often, a budget will be prepared a year in advance, but it could be on a monthly or quarterly basis. The stages involved in budgeting:

Budgeting is anticipating what you think will happen in the future and planning for it. Budgets for individual areas should link together, so the production budget should be based upon the sales budget. The marketing budget must take into account how much we can make etc. Budgets are useful for several reasons

1. They provide targets for people to work towards, and so should therefore be motivating. 2. They allow planning, so problems can be seen and action taken before a crisis emerges. 3. They allow delegation. Managers can afford to allow juniors more freedom because they have these

pre-set limits to work within and so cant go too far wrong. 4. Can check the performance of the organization, as you have already worked out how well you think it is

going to do. There is, as usual, the odd problem with them.


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1. If targets are too hard to reach employees might settle for an easy life rather than working hard to try and meet a target that they wont reach anyway.

2. People may resent having targets imposed on them, so its important to involve them when setting the budget.

3. If budgets are too rigid, then opportunities may be missed. For example, if all of the promotional budget is spent, and an export opportunity comes up, then it would be stupid not to follow up on it just because the promotional budget was spent.

Variance Analysis One of the most important aspects of Budgets is the review stage. It is not enough to set targets and just leave it to take care of its self. You must review whats going on and take action this is called variance analysis. The basic idea is dead simple. You just look at the difference between the budgeted number and what actually happened. The important bit is deciding if it is a positive or a negative variance. Positive variance is when it is good (not necessarily when it is more than), and negative variance is when it is bad. So, if sales were less than the budgeted amount this would be a negative variance. If expenses were less than the budgeted amount then this would be a positive variance. N.B. Both positive and negative variances need investigating. E.g. If advertising was under spent, then this might have a knock on effect on sales. There are loads of different ways of setting budgets. Some of them are Zero Budgeting Each year we start from zero. Every part of the budget is justified. Each manager has to say how much money they think they will need, and why. The idea is that the money (or other resource) is allocated where it is needed most, and not just because that is how it is always done. Incremental Budgeting Budgets are set according to what you got last year, plus a bit more. This is a common method because it is easy to understand, and is fairly easy to do. It is however, inflexible, Means unexpected events are not taken into account. Also it assumes that last year will be the same as the next. Competitor parity budgeting Expenditure is set in line with what competitors spend. The idea is that we can make use of their knowledge of the market, and it avoids costly marketing wars. This is however mince. Firstly, how do we know what our competitors spend? Secondly, how do we know that what they spend their money is what we need to spend money on? Finally, there is little evidence that it does avoid costly wars. Variance analysis The one of the main points of a budget is to be able to see if we actually did what we thought we were going to do. This is important because

It means we can try and make next years budget more accurate Spot problems, and therefore take action to resolve them.

IF THERE IS VARIANCE IS BECAUSE

More money than expected in

Less money than expected out

FAVOURABLE

Its GOOD for the business its

POSITIVE.

+

More money than expected out UNFAVOURABLE Its BAD for the business its NEGATIVE (ie adverse).


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Less money than expected in - Management by exception When investigating and analysing variances, it is common for managers to concentrate on the large positive and large negative variances and ignore (i.e. except) the smaller variances. This is known as management by exception and involves the managers focussing their attention on those areas which have resulted in large overspending or underspending, and attempting to discover the reasons behind it.

EXERCISES1

QUESTION 1: Consider the following data which has been extracted from the budgeted figures and the actual figures of a well-known business (Turnbulls Tanks):

Budget Actual Variance 000 000 000 % diff A/F? Sales Revenue 500 605 Raw materials 200 220 Labour costs 100 110 Advertising 50 45 Delivery 20 20 Utility bills 15 16

1 (a) Fill in the blanks. 1 (b) Produce an analysis, broken down by Sales Revenue etc.

QUESTION 2: You are the manager of Dishy-Dashy Clothing, which manufactures and exports jeans and other items of High Fashion denim clothing often worn by teachers. The table below shows your estimated sales figures for a new design for jeans for the first 6 months:

Month JAN FEB MAR APR MAY JUN Units 200 190 210 260 340 400

You are aiming for the mass-market, therefore you plan to sell them for $10 per pair from January to June. After that, from July to December, you plan to increase the price to $11.

1 Check your answers at the end of the guide.


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Based on previous experience, you expect the following sales from July to December:

Month JAN FEB MAR APR MAY JUN Units 400 340 310 300 200 150

Your raw materials are JIT at $5 per month for every unit. E.g., in January raw materials costs are $5 x 200 = $1000. Labour costs remain static from January to April, and from September to December $1000 per month. For the remaining 4 months (May August) additional staff will be employed and your labour costs will be $1250 per month. You are expected by the managing Director to contribute $5000 per annum towards the companys fixed costs. Your company operates a Zero Budgeting policy. You must show that your budgeted sales revenue exceeds your budgeted costs (including the $5000 of fixed costs)? Will you meet this target?

QUESTION 3: Please read the Kraft case study below and answer the following questions: (a) List the reasons why Kraft uses budgets. (b) List the stages involved in Kraft constructing a budget (c) Very briefly explain why Kraft attach importance to feedback (d) What mix of budget types should Kraft choose, and why? 1. Introduction: budgeting and strategy at Krafts Kraft is the worlds second largest food company, employing 110,000 staff in 60 countries. The company originated in Chicago as a wholesale cheese business in 1903. Since then it has experienced continual growth by merging (joining together) with and acquiring (taking over) other businesses. Today it has a range of powerbrands that are household names. For example:

Category Brand Acquired

Coffee Kenco 1987 Confectionery Terrys Chocolate Orange 1993 Cheese Philadelphia 1928 Cheese Dairylea 1950

Kraft Inc is a public company; its shares traded on the New York Stock Exchange. Kraft Foods UK Ltd. is the wholly owned subsidiary responsible for the groups food manufacture and distribution in the UK (and Ireland). It employs more than 2,500 people, and is a significant part of the worldwide organisation. 2. What is a budget? A budget is a financial plan that sets out, using figures, an organisations expected future results. For planning purposes, organisations can use many different types of budgets. For example: Income and expenditure budgets. These show how much an organisation expects to receive and to spend

in future periods. Production budgets. These set out how much an organisation must produce in coming periods of time in

order to meet demand. Profit budgets. These bring together planned sales, costs, and profit figures.


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By creating budgets, managers can: set out a clear plan, involving target figures for defined periods of time communicate their targets clearly motivate employees to achieve these targets control performance by monitoring actual outcomes against planned targets meet the organisations objectives. This Case Study illustrates how Kraft Foods uses budgets to enable it to meet business objectives related to financial performance with a view to achieving its vision: to become the undisputed global food leader. Kraft has several important objectives related to its vision. These include: being the employer of choice being a food industry high performer becoming an indispensable partner to customers being a responsible organisation and a positive force in the communities in which Kraft employees live,

work and make its products remain focused and innovative. Budgets help Kraft to meet these objectives in a planned forward-thinking way. Budgets are created through consultation with all areas of the business, to achieve a shared understanding about objectives for the future visions of their teams. The Finance team supports and contributes to the work generated by other business functions to build and secure their support for the budget. To be effective Kraft recognises that a budget must be challenging but also realistic, so that people feel it can be achieved and is worth working towards. One important element is to identify cost savings that can be re-invested to continue to grow Krafts powerbrands and to develop its people. Reducing costs by eliminating waste is vital in the modern food industry which is driven by price competition and consolidation in the retail sector. 3. Krafts income and expenses budget A typical budget: relates to a defined time period (usually twelve months) is designed and approved well in advance of the period to which it relates shows expected income and expenditure includes all capital expenses likely to be incurred in furthering the organisations objectives. Income is the amount of money a business receives from its sales. Expenses are the costs incurred in order to make those sales. To help control expenditure the Finance team collects the costs of the business in relevant groups called cost centres, so that analysis can be meaningful and also well controlled by those directly responsible for authorising the spend. Many companies, including Kraft, use cost centres that relate to particular factories or production units. Within Kraft each manager is assigned clear responsibility for governing the costs which are allocated to his/her cost centre. The budgeting process enables Kraft to make clear plans for individual cost centres, which build the budget for the whole organisation. The whole purpose of this exercise is to quantify the likely future costs of the whole operation, whilst always maintaining focus on the future plans for the company.


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Kraft sells its wide portfolio of products to a variety of different customers; ranging from the corner shop, to the cash and carry and large multinational supermarket chains. In doing so, it incurs: raw material costs and production costs to manufacture the products to sell marketing expenses associated with any promotional activity including media advertising selling expenses involved in selling its goods into supermarkets and other customers distribution expenses when transporting the products from its European and UK factories to the customer. The starting point for building a budget is to forecast the likely sales based on historical information in conjunction with Krafts and third party understanding of the business environment. This indicates what quantities of products need to be produced and the timing of manufacture. With these figures in place, budgets can then be allocated for costs relating to sales, marketing and administration, and figures established for the likely costs of storing and transporting the goods (i.e. distribution). These details provide data for relevant departments (e.g. sales, administration etc). Figures can then be inserted for likely capital expenses. The final stage is to construct a budgeted profit and loss account and balance sheet. Once the budget has been set and agreed by the management teams within Kraft, it becomes the mechanism through which managers monitor progress on a particular business component (for example, a brand, or factory) or on total company performance. 4. The importance of feedback The budgeting process is a cycle of ongoing review and monitoring. Every month, Kraft uses variance analysis to identify deviations within the monthly result. A variance is the difference between the budgeted figure and the actual figure. Variances can be favourable or adverse. For example, if actual sales income was greater than budget, this would be a favourable variance. On the other hand, if actual expenses were greater than budget, this would be an adverse variance. By monitoring performance monthly, it is possible to alert cost centre managers to variances so that they can take appropriate corrective action or justify the new level of spend. At all stages the Senior Management team of Kraft is fully aware of any material variances that are derived from comparing actual spend vs budgeted figures. Periodic reviews which are organised by the Budget Accountant, allow there to be a forum within which any feedback can be given on current actual spend vs plan, ensure that it is possible to reforecast the plan or alter current activity. Single loop feedback involves making correction to current activities in order to get back on course. Double loop feedback involves amending the original plans so that they more accurately reflect current business reality. In a company like Kraft, this ability to amend the budget is an important aspect of management. Krafts operating environment is subject to rapid change, for example, in consumer demand patterns, in production technology, in competitor activity. So Kraft has to remain flexible and ready to respond to any challenges that it faces. Any one budget may be altered a number of times during a year, although there would always be a considered reason for doing so. 5. Constructing an expense budget Each cost centre budget is seen as part of an overall plan designed to meet company objectives. Constructing cost centres individual budgets involves detailed consultation about company objectives, marketing objectives


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and relevant income and expense projections. These can be brought into line and match changes in the external business environment. Using this as a basis it is a reasonably straightforward exercise to calculate other expenses, including the number of people (and their remuneration packages, such as pension expenses, national insurance, travel costs) required to run a particular part of the business. In the modern business world the rate of change is such that it is impossible to have a clear picture of the future. Inevitably it takes time to build the big picture from lots of small, shifting scenarios relating to individual cost centre budgets. Budgeting may be difficult, but it is essential for a business to stay in control and ahead of the game. 6. Advantages and disadvantages of expense budgeting Budgeting provides organisations with detailed analysis of future and current proposed spending patterns, enabling much better control (by responding to variances). Performance can be analysed quantitatively (in numbers), making it possible to measure financial success. Measurement of results can serve as a motivational tool for many employees. Budget analysis also makes it possible to identify unnecessary costs that can be removed so as to focus funds on value adding activities. Kraft uses budgetary control to remain focused on the hard (quantitative) and soft (qualitative) benefits of re-distributing spend. However, it is important to keep sight of the organisations long term goals to avoid the risk that budgeting might lead to short-term focus on financial results. This could foster cost cutting exercises at the expense of strategy. In the worst case, individual managers may pursue exclusively their own narrow goals rather than business wide ones. If individual managers are not happy with the budget they may co-operate poorly, so it is important to have detailed discussions to achieve collective agreement. This is why Kraft as an organisation retains a consultative approach to constructing budgets. 7. Alternative types of budgeting There are a number of budgeting types to choose from. Kraft uses a mix of the following: Zero based budgeting In a dynamic business it often makes sense to start afresh when developing a budget rather than basing ideas too much on past performance. This is appropriate to Kraft because the organisation is continually seeking to innovate. Each budget is therefore constructed without much reference to previous budgets. In this way, change is built into budget thinking. Strategic budgeting This involves identifying new, emerging opportunities, and then building plans to take full advantage of them. This is closely related to zero based budgeting and helps Kraft to concentrate on gaining competitive advantage. Rolling budgets Given the speed of change and general uncertainty in the external environment, shareholders seek quick results. US companies typically report to shareholders every three months, compared with six months in the UK. Rolling budgets involve evaluating the previous twelve months performance on an ongoing basis, and forecasting the next three months performance. Activity based budgeting


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This examines individual activities and assesses the strength of their contribution to company success. They can then be ranked and prioritised, and be assigned appropriate budgets. 8. Conclusion The world food market is dynamic and highly competitive. To succeed, Kraft recognises the need to build in flexibility that enables it to seize appropriate opportunities into its planning activities. Krafts budgeting process is based on consensus, and shared understandings. By using rigorous but flexible budgeting arrangements the various components of Kraft are best able to contribute in a coordinated way to delivering strategic objectives.


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ANSWER 1 1 (a)

TURNBULLS TANKS LTD Budget Actual Variance

000 000 000 % A/F Sales revenue 500 605 105 F 21 F Raw materials 200 220 20 A 10 A Labour costs 100 110 10 A 10 A Advertising 50 45 5 F 10 F Delivery 20 20 0 0 Utility bills 15 16 1 A 7 A

1 (b) This business has six budget-heads listed: It budgeted to have sales revenue of 500,000 for the year, but actually managed to sell

605,000 of products. This leaves a variance (the difference between the budgeted sales revenue and the actual sales revenue) of 105,000 (or 21% of the budgeted figure). This is a favourable variance (F), because it results in the business receiving more revenue than it budgeted for.

The business budgeted to purchase 200,000 of raw materials. It actually spent 220,000

on raw materials. This is a variance of 20,000 (or 10% of the budgeted figure). This is an unfavourable or adverse variance (A), because it results in the business spending more money than it budgeted for.

Similarly, the business budgeted to spend 100,000 on its labour costs (wages and

salaries). It actually spent 110,000 on its labour costs. This is a variance of 10,000 (or 10% of the budgeted figure). Again, this is an unfavourable or adverse variance (A), because it results in the business spending more money than it budgeted for.

The business budgeted to spend 50,000 on its advertising for the year, but it actually

spent only 45,000. This is a favourable variance (F) of 5,000 (or 10% of the budgeted figure), since it results in the business spending less money than it budgeted for.

The distribution budget was 20,000 and the actual cost of distributing the products was

20,000. Therefore there is no variance, since the actual figure was the same as the budgeted figure.

The budgeted figure for the utility bills was 15,000. However, the utility bills actually cost

16,000. This is an adverse (A) variance of 1,000 (or 7% of the budgeted figure), since it results in the business spending more money than it budgeted for.


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ANSWER 2

BUDGETED REVENUE Jan to Jun 1600 units at $10 per unit 16000 Jul to Dec 1700 units at $11 per unit 18700

REVENUE TOTAL 34700 BUDGETED COSTS Raw materials 3300 units at $5 16500

8 months at $1000 8000 Wages 4 months at $1250 5000 Fixed costs 5000

COSTS TOTAL 34500 There is a surplus of $200, so the answer is yes, the company will be able to earn enough revenue to cover its costs.

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