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IB BUsiness MAnagement:
The financial planning process is known as budgeting. a budget is a detailed, financial plan for a future time period.
If no financial plans are made, an organisation drifts without real direction or purpose. Managers will not be able to allocate the scarce resources of the business effectively without a plan to work towards. Employees working in an organisation without plans for future action are likely to feel demotivated, as they have no targets to work towards - and no objectives to be praised for achieving.
If no targets are set, then an organisation cannot review its progress because it has no set objective against which actual performance can be compared.
Purposes of setting budgets and financial planNing:
Stages in setting budgets
The info-graphic on the right shows how budgets are commonly prepared. This involves seven stages:
The most common organisational objectives for the coming year are established. These will be based on:
The key or limiting factor that is most likely to influence the growth or success of the organisation must be identified - this is usually sales.
The sales budget is prepared, after discussion with sales managers in all branches and divisions of the business.
Subsidiary budgets are prepared, which will now be based on the plans contained in the sales budget. These will include:
These budgets are coordinated to ensure consistency.
A master budget is prepared that contains the main details of all other budgets and concludes with a budgeted profit and loss account and balance sheet.
The master budget is presented to the board of directors for approval.
How budgets are commonly prepared
This flowchart outlines the key factors and stages in the preparation of a typical business budget.
Two ways to set budget levels:
1. Incremental budgeting
Definition: Incremental budgeting uses last year's budget as a basis and an adjustment is made for the following year.
In many businesses that operate in highly competitive markets there may be plans to lower the cost budget for departments each year, but to raise the sales budgets. This puts increased pressure on many staff to achieve higher productivity. Incremental budgeting does not allow for unforeseen events. Using last year's figure as a basis means that each department does not have to justify its whole budget for the coming year - only the change or 'increment'.
2. Zero budgeting
Definition: Setting budgets to zero each year and budget holders have to argue their case to receive any finance.
This approach to setting budgets requires all departments and budget holders to justify their whole budget each year. This is time consuming, as a fundamental review of the work and each budget-holding section is needed each year. However, it does provide added incentive for managers to defend the work of their own section. Also, changing situations can be reflected in very different budget levels each year.
During the period covered by the budget and at the end of it the actual performance of the organisation needs to be compared with the original targets and reasons for differences must be investigated.
Budgetary control: Variance Analysis
Variance Analysis: The process of investigating any differences between budgeted figures and actual figures.
Adverse variance: Exists when the difference between the budgeted and actual figure leads to a lower than expected profit.
Favourable variance: Exists when the difference between the budgeted and actual figure leads to a higher than expected profit.
Potential limitations of budgets:
Budgeting and variance analysis
Importance of Variance Analysis
Progress check - test your understanding by completing the activities below
You have below, a range of practice activities, flash cards, exam practice questions and an online interactive self test to ensure you have complete mastery of the IB Business Management requirements for the Finance and Accounts 3.9 Budgeting topic.