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3.9: Budgets

Cost and profit centres

  • Cost Centers:

  • Departments that incur costs but don't generate revenue.

  • Costs are allocated to specific activities.

  • Managers are responsible for monitoring and managing costs.

  • Help identify areas with high costs.

  • Profit Centers:

  • Departments that incur costs and generate revenue.

  • Managers are responsible for costs, revenues, and profit.

  • Used by large, diversified businesses.

  • Identify profitable and less profitable areas.

  • Advantages of Cost and Profit Centers:

  • Improved Financial Control: Better monitoring of costs and revenues.

  • Performance Assessment: Compare different sections' financial performance.

  • Autonomy: Empowers managers to make decisions.

  • Motivation: Rewards managers for meeting targets.

  • Accountability: Holds managers accountable for performance.

  • Disadvantages of Cost and Profit Centers:

  • Allocation Challenges: Allocating indirect costs can be subjective.

  • Profit Distortion: Fixed cost allocation can affect profits.

  • External Factors: External factors can influence department performance.

  • Data Collection: Requires time and resources.

  • Potential for Competition: May create internal competition and tension

Constructing a budget

  • A budget is a financial plan outlining expected revenue and expenditure for a specific period. It helps allocate resources, monitor performance, and control business activities.

  • Types of Budgets:

  • Flexible Budgets: Adjust to changes in the business environment.

  • Incremental Budgets: Increase previous year's budget by a percentage.

  • Marketing Budgets: Plan marketing activities.

  • Production Budgets: Plan output levels and stock costs.

  • Sales Budgets: Forecast sales volume and revenue.

  • Staffing Budgets: Plan labor costs.

  • Zero Budgeting: Starts with a zero budget and requires approval for all expenditures.

  • Master Budget:

  • The consolidated budget for the entire organization.

  • Managed by the Chief Financial Officer (CFO).

  • Includes capital expenditure plans.

  • Considerations for Budget Construction:

  • Financial Strength: The amount of funds available.

  • Historical Data: Past trends and economic forecasts.

  • Organizational Objectives: Growth plans and goals.

  • Benchmarking: Comparing to competitors' budgets.

  • Negotiations: Discussions between budget holders and CFO.

Variances

  • Budgetary Control

  • Budgetary control is the process of monitoring budgets, investigating variances, and taking corrective measures to ensure actual outcomes align with budgeted expectations.

  • Variance Analysis:

  • Variance: The difference between budgeted and actual outcomes.

  • Favorable Variance: Financially beneficial discrepancy (e.g., lower costs, higher revenue).

  • Adverse Variance: Financially detrimental discrepancy (e.g., higher costs, lower revenue).

  • Steps in Budgetary Control:

  • Compare actual and budgeted figures.

  • Identify variances.

  • Investigate causes.

  • Take corrective measures.

     

Importance of budgets and variances in descions making

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  • Purposes of Budgeting and Variance Analysis:

  • Planning and Guidance:

  • Helps anticipate financial problems and prepare accordingly.

  • Allocates resources to departments.

  • Provides guidance for decision-making.

  • Coordination:

  • Aligns individual actions with organizational goals.

  • Ensures consistent and transparent decision-making.

  • Prevents conflicts between departments.

  • Control:

  • Monitors and controls spending.

  • Identifies areas of overspending.

  • Holds managers accountable for financial performance.

  • Motivation:

  • Empowers budget holders and promotes autonomy.

  • Encourages teamwork and motivation.

  • Recognizes and rewards performance.

  • Limitations of Budgeting and Variance Analysis:

  • Unforeseen Changes: Unexpected events can make budgets inaccurate.

  • Overestimation: Managers may overestimate budgets to ensure they meet targets.

  • Carry-Forward Restrictions: Surplus funds may not be carried over to the next year.

  • Top-Down Budgeting: Senior managers may not fully understand departmental needs.

  • Inflexibility: Budgets may not adapt well to rapid changes in the business environment.

  • Qualitative Factors: Ignores non-financial factors like social responsibility, employee motivation, and environmental impact.

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