30 Budgets A Activity 30.1 (page 559): Variance analysis at Oasis Cookers Ltd 1 Calculate the variances and indicate whether they are favourable or adverse variances. [6] Variance is the difference between the budgeted figure and the actual outcome. Budgeted figures ($000) Sales revenue Cost of materials Labour costs Gross profit Overheads Net profit 2 3 Actual figures ($000) 165 80 22 63 40 23 150 70 23 57 43 14 Variance: $000 15 adverse 10 favourable 1 adverse 6 adverse 3 adverse 9 adverse Explain two possible reasons for the variances in: • sales revenue [4] – Lower sales due to the downturn in the economy – with no economic growth, unemployment will increase and consumer spending will fall. – Reduced selling price in order to stay competitive – difficult trading conditions and the appreciation of the currency will lead to a decrease in the price of foreign imports. • labour cost. [4] – Higher wages paid to employees – this could be a result of inflation in the economy and workers demanding higher wages to maintain their real standard of living. – Productivity of labour lower than expected – this means each unit of work will take more time and cost more. Evaluate two ways in which the management of Oasis Cookers could respond to these variance-analysis results to improve performance of the business. [10] • Reduce costs of inputs into the cookers – this could be done by importing components and thus taking advantage of the appreciation in the currency. Oasis Cookers would have to ensure that supplies were of a satisfactory quality and that suppliers could meet the lead times necessary to keep production flexible. If lead times are long and not reliable, then Oasis Cookers would have to stock more raw materials if sourced from abroad. Chapter 30 © Cambridge University Press 2010 1 • A 4 Automate production lines to reduce labour costs – this would require substantial capital investment, so might be a problem as net profit is low and the economy is not growing. Automation might lead to industrial relations problems, and redundancy payments would be a drain on resources. Automation might also lead to an increase in the overheads of the business due to increased energy consumption and depreciation. Calculate the variances for each type of overhead cost and indicate whether they are favourable or adverse. [4] Overhead costs Promotion and distribution Administration Production Personnel 5 Budgeted figures $000 8 9 22 1 Actual figures $000 6 8 27 2 Variance $000 2 favourable 1 favourable 5 adverse 1 adverse Evaluate the benefits of setting budgets and using variance analysis to manufacturing businesses such as Oasis Cookers Ltd. [14] Benefits include: • Budgets help plan for the future. A budget provides a target for departmental managers to achieve. • Setting targets can help motivate staff, particularly if they have had some input into the budgetary process. Employees may feel a sense of achievement when targets are met. • Budgets help control costs and improve efficiency. This is important to Oasis Cookers as the external economic environment is not favourable and being price competitive will be important. • Budgets aid assessment of the organisation. If actual outcomes diverge from those budgeted, managers can investigate what has happened and try and resolve problems. • Budgets can aid coordination. The budgeting process can ensure that all parts of the business are working toward the same objectives and that those objectives will be met. Evaluation may consider: Budgets and budgetary control will only be effective if they are: • realistic • agreed by those with responsibility for meeting the budget • coordinated with objectives • challenging to ensure efficiency • flexible. Chapter 30 © Cambridge University Press 2010 2 A Revision case study 1 (page 561): Karmali Carpets plc 1 Comment critically on the managing director’s approach to budgeting. [6] The managing director’s approach to budgeting can be criticised on the following grounds: • The budget was not discussed with the sales manager. It is beneficial to consult the sales manager so that the resulting budget is considered to be fair. • The budget was provided to the sales department late in the year. Sales did not have the targets earlier enough to act on them. • The budget was unrealistic. As a result of the lack of communication between the managing director and the sales manager, the budget set was too ambitious. A budget should be achievable if it is to motivate staff. 2 Write a report to the managing director explaining the likely advantages to his business from a delegated budgetary control system using the stages of the budgeting process as outlined in this chapter. [12] A budget is a detailed financial plan, usually for the next 12 months, which sets out financial targets for sales revenue and costs. A delegated budget involves discussion with the various budget holders before setting the targets, so as to give budget holders a sense of ownership over those targets. Budgets have the following key benefits: • aid to planning • ensuring an effective allocation of resources between departments • providing achievable targets • coordinating departments to ensure that there is effective teamwork • monitoring and controlling • amending budgets if it becomes clear that objectives cannot be reached • assessing performance. The budgeting process can be split into a number of stages to achieve the benefits listed above: • Set organisational objectives taking account of external factors and previous performance. In this case, profit targets will need to be carefully set as profits have been falling. The delegated budgets will then work toward achieving these objectives. • Prepare sales budget for carpet sales with Sarah Fellows. This will ensure that the budget is achievable and will provide motivation for employees. As the budget holder, Sarah must be involved in setting targets to ensure that she has ownership of the targets rather than them being imposed on her. • Prepare subsidiary budgets, including cash budget, administration and others. • Ensure that budgets are coordinated. This will avoid conflicts between budgets, e.g. it will need to be decided if advertising needs to be increased. • Prepare the master budget. • Present master budget to the board for approval. Once approved, the budgets will become the operational plans of each department and will be broken down into short time periods. Chapter 30 © Cambridge University Press 2010 3 A Revision case study 2 − answer provided on Student’s CD-Rom. Essay 2 a Explain the terms: b • zero budgeting [4] This is a method of setting budgets. All budgets are set to zero each year and budget holders have to justify why they should receive any finance. Thus, each department has to make a case for everything that it wants to spend. It is, therefore, time consuming, but does allow for significant changes to made to budgets from one year to another to take account of external events. • flexible budgets [4] This recognises that the level of output will not necessarily be at the budgeted level and, consequently, will affect cost budgets. With flexible budgets, the cost budget for each expense is allowed to vary if sales or production vary from budgeted levels. The advantage of a flexible budget is that it is more likely to highlight variances, which are a result of real efficiency problems. • adverse variance. [4] This occurs when the actual outcome is worse than the budgeted target. For all budgets relating to costs of the business, if the actual outcome is greater than the budget, it is an adverse variance. For revenue budgets, if the actual outcome is lower than expected, it is an adverse variance. Discuss the view that a budgetary system is a waste of time and effort for a business operating in a rapidly changing market and economic environment. [13] Benefits of setting budgets include: • The process of setting budgets helps coordination between departments. • If budgets are delegated, they can aid motivation of managers and employees. Departments are more likely to control their costs if they have been involved in deciding the targets. • Setting targets provides goals for departments to achieve; this can improve motivation as long as the targets are realistic. • Budgets provide a benchmark for assessing the performance of managers. • Without a budgeting system, it would be difficult to allocate resources. • Setting a sales budget provides the foundations for making decisions on the needs of the business in terms of human resources and how much to spend in each department. Budgets in a rapidly changing market and economic environment: • Budgets are not forecasts; they provide targets for departments. • Budgets can be set flexibly and part of the budgeting process is to review budgets periodically to assess progress toward targets. • Budgets consume management time to set; it could be argued that this time is wasted if change in the economic environment renders the budget meaningless. • Variance analysis will review why budgets have not been met. This is a useful monitoring process and will help identify efficiency problems. Chapter 30 © Cambridge University Press 2010 4 A Evaluation may consider: If businesses do not try to plan for the future, they are more likely to fail to achieve their objectives. Budgets can fulfil a coordinating function and help motivate managers. The benefit of budgeting lies largely in the process that is followed to set a budget. Although markets and economic conditions change rapidly, businesses still need to monitor and control costs – budgets help achieve that goal; they are an integral part of financial planning and control. Chapter 30 © Cambridge University Press 2010 5
