Finance - Budgets

How business use Budgets.

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  • Created by: sonny
  • Created on: 16-05-11 20:46

Know your definitions!

Budget - A budget is a detailed plan of income and expenses expected over a certain period of time.

Income Budget - This sets the minimum targets for the desired revenue level to be achieved over a certain time period. Previous sales figures are used for this as well as market research.

Expenditure Budget - This is a maximum target for costs that a manager may be able to spend over a certain timescale. Managers need to predict what the output will be so they can work out the variable costs.

Profit Budget - This Uses income and expenditure budgets to calculate what the expected profit or loss will be.

Budget Holder is someone whom is responsible for spending or generating the profit. When department managers delegate authority to budget holders, it can motivate them.

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Why Budget?

Analysis - This is to make that the business run smoothly by the higher management can find a way to allocate money to the employees so that they can make spending decisions themselves. But the managers do not want to bankrupt the firm so they will use a budgets to allow the employee to decide what to spend, and making sure they have a limit so as not to overspend.

Application - For example; if you own a hair salon and want to open another one, then you would need a manager so you are not travelling back and forth from each shop. You would need to make a budget for that manager so that they know what to spend on what and have a clear idea of how much they can spend so that they don’t overspend.

All the departments are allocated their own budget which all feed into the master (overall) budget.

Motivation - Being apart of the setting of the budgets can make you feel valued and motivatedto meet your budget.

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Benifits VS Drawbacks

Benifits of budgeting:

  • Creates guidelines and help to control costs
  • provide direction and coordination - spending is geared towards the aims of the business 
  • Can motivate staff if they are involved in the planning, which relates to Maslows heiheracy and Hertzbergs Two Factory theory. Then if they manage to keep to there budget they will reach self fulfilment/actualisation! Being given some authority is also a way of motivation.
  • It helps to indicate areas/activities of high priority.
  • They improve efficiency: by monitoring budgets the business can evaluate the causes of any successes or failures and improve in the future.
  • Assess forecasting ability: budgeting encourages careful evaluation of the future possibilities and realistic planning.
  • It can show if a business is organised and this would make them appealing to investors because they would want to know if the business is planning their money efficiently.
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Drawbacks Of Budgeting.

  • Allocations may be incorrect - It is just a prediction and unexpected occurences may happen at any time. Insufficent budgets may demotivate staff. 
  • Savings may be sought that are not in the intrest of the firm - buying cheaper materials may lower the quality of the end product, causing cutomer discontent.
  • Difficult to monitor - senior managers will be less aware of detailed expenditure and costs, therefore will rely heavily on honesty of budget holder in explaining a departments needs.
  • Poor Communication - Budgets must be agreed between people who understand the area in question and also other factors.
  • Unforeseen oppurtunities - There could be an oppurtunity cost that you may of been able to buy a truckload of materials at a reduced cost or you be offered a special opportunity to break into a new market with an endorsement that you could not have foreseen.
  • Resentment and rivalry can be created if departments have to compete for money.
  • Can be time consuming and means not spending time on customers etc.
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Features of good budgeting

  • Considering others opinions - be aware of as many peoples views as possible as this will increase ideas and expertise, therefore allowing you to create a realistic set of budgets/targets.
  • Monitor your budgets regularly - Allowing changes in the business is easier the more you actually look at your budgets which means actions can be put in place. E.g. if something breaks reviewing your budget to maybe add a little more due to the unforeseen crises may be a good idea to be flexible if needed.
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Historical Versus Zero Budgeting

Historical Budgeting is based on a percentage increase or decrease from last years budget. E.g. A business expecting a 10% revenue increase will increase raw materials, advertising etc by 10% as well. This method is quick and easy.

Historical budgeting assumes that the business's conditions don't change but if sales volumes increase unit costs may fall due to economies of scale. Or the stage of the product in the product life cycle might of changed from last year. A product in the introductory stage will need more advertising then if it was in the mature period etc.

Zero Budgeting is more flexible and will allow the budget to be adjusted in response to a significant in the market or economy. Budgets start at nothing, and all activities need to be approved. All the years expenses needs to be forecast and the budget holder needs to be able to justify their request and therefore need good negotiating skills.

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Variance Analysis - This involves assessing the difference between the budgeted and actual amounts and highlighting reasons for this difference.

There are two types of Variances, these are Favourable which means better then expected, I.E. Actual amounts are better then budgeted. Or they can be Adverse meaning that they are worse then expected I.E. actual amounts for the expenditure budget are higher than budgeted.

Variences are easy to to work out, the formula is: Budgeted Figure minus Actual Figure.

Variences can indicate:

  • Unsuitable method of budgeting is being used.
  • Poor Management
  • Dynamic Market e.g. new laws, changes in trends or the economy and unanticipated events such as a printer/heat press breaking for a t-shirt printing business.
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Factors of variances


  • Improving efficiency e.g. by introducing automated production equipment.
  • A business might under or overestimate the cost of making a change to its organisation.
  • Changing the selling price can change the sales revenue.
  • Poor management or communication.


  • Competitor behaviour and changes in fashion or trends may increase or decrease the demand for products.
  • Changes in the economy can change how much workers' wages cost.
  • The cost of Raw Materials can go up - e.g. if crops fail.
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Variance analyse to inform decision making.

Small variances, both adverse and favourable believe it or not can motivate staff. Adverse variances make staff try and catch up and sort them out themselves. Favourable variances can motivate staff to keep doing what they are doing and continue to work hard.

Large variances are the opposite however. Both fav and adverse variances demotivate staff. If the change is favourable, they don't see the need to work hard. If the change is adverse, they will feel that they aren't doing a good job and will think that they have already failed, or think the task is impossible.

Changing the budget removes certainty - which reverses one of the big benefits of budgets. When targets are changed instead of doing something to change performance, staff don't see the point in trying anymore.

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Businesses try to fix both adverse and favourable

To fix adverse variances:

  • Change the marketing mix - Cutting prices will increase demand if the product is is price elastic. Updating the product can make it more appealing. They can also go into a new market, or try a new promotional strategy. 
  • Streamlining production makes the business more efficient and therefore saves money.
  • They can try to motivate employees to work harder.
  • Businesses can try to cut costs e.g. by asking supplier for a better deal.

To fix variable variances:

  • If caused by a pessimistic budget, they can set more ambitious targets next year.
  • If the variance is due to increased productivity in one part of the business, they try to get everyone else doing whatever was responsible for the improvement and set higher targets in the next budget.
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Practice Questions


1) What are the three types of budgets and what do they show?

2) If a business has an income budget of 125,000 and a profit budget of 30,000, what is the expenditure budget?

3) State three benifits and drawbacks of creating budgets.

4) What is historical budgeting?

5) Explain the difference between fixed and flexible budgets.


1) Expenditure budget is 15 000, the actual expenditure is 18 000. What variance is it? And what is the difference?

2) How do businesses deal with variances?

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very useful information


but not very influencing

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