Chapter 32 - Budgets
Lesson Objective: To understand how to perform variance analysis
It is obvious: budgets are controlling tools:
At the end of every budget period there needs to be an assessment comparing the company's aims and the actual performance. This process is called budgetary control.
Any differences found between the aims and the actual performance are to be investigated. This is called variance analysis and it's an important part of budgeting for several reasons:
It measures the differences from planned performance of the different departments on a month-by-month basis at the end of the year;
It assists on finding the causes of deviations;
The causes of deviations can then be used for a more accurate next budgeting;
Variances can be of two kinds:
Favorable: when the deviation effect is positive (increased profit through increased sales, for example);
Unfavorable (adverse): when the deviation effect is negative (decreased profit because of higher cost of materials than what’s been budgeted, for example)
Let's have a look at some examples:
The net (profit) variance for this business budget can be verified by adding all of the favorable and adverse variances:
Adverse: 3500
Favorable: 1000
(Net) Profit Variance = 2500
Variance Analysis is useful for business for two main reasons:
- Quick identification and remediation of problems (adverse variances);
- Management by exception: managerial resources can be allocated and concentrated on major problem areas as necessary (in the case above, sales).
One of the most common causes of adverse variance is sales revenue below budget (sales volume lower than planned or selling price had to be lowered). Other causes include:
Variance Analysis can focus on different elements:
Raw material costs higher than budgeted;
Labor costs above budgeted (wages had to be raised or productivity decreased or more time was taken to produce one unit);
Overhead costs higher than budgeted (e.g. annual rent raised).
Responding to variance analysis:
Adverse variances need to be remediated quickly;
Favorable variances also need to be fixed - maybe budgets were set too high in the first place.
Quick evaluation of budgets and controls - are they worth it the time, training and cost?
Without budgeting it'd be difficult to allocate resources;
How much to produce, spend, and how many people to employ would be difficult to estimate;
Allows for assessment of businesses and departments leading to easier implementation of necessary changes.
Activity 32.3
To-Do-List:
Chapter 32 - Budgets
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