Preparing corporate budgets
A budget is a plan in money (or units) for a future period, usually a year split by month. Steps:
- Find the limiting factor (often sales). Make the sales budget first.
- From sales, make the production budget (units to make = sales + wanted closing stock - opening stock).
- Then budgets for materials, labour and overheads: the cost budget.
- Make the cash budget: cash in and out by month, so the firm can plan loans.
- Join all into the master budget: budgeted profit and loss, and balance sheet.
Managers of each unit take part, so that the budget is accepted and realistic.
Budgetary control methods
Budgetary control means using budgets to guide and check work. The cycle: set the budget, record actual results, compare, report variances, take action.
Variance = Actual - Budget. For sales or profit, higher than budget is favourable. For cost, higher than budget is unfavourable.
Common methods:
- Static (fixed) budget: does not change when activity changes.
- Flexible budget: restated for the actual activity level, so the comparison is fair.
- Zero-based budget: every item must be justified from zero each period.
- Rolling budget: as one month ends, add a new month at the end.
Reading variances and acting
A variance is a question, not a verdict. Ask: is the cause outside our control (price rise) or inside (waste)? Is it one-off or will it repeat? Managers then act: change prices, cut waste, or revise the plan. Report by exception: only big variances go to senior managers, so they are not buried in numbers.
Try it: a flexible budget
Budget for 1,000 units: cost $7,000, of which fixed $2,000 and variable $5 per unit. Actual output was 1,200 units and cost $8,300. A static comparison says $1,300 over. The flexible budget for 1,200 units is 2,000 + 5 × 1,200 = $8,000, so the true overspend is only $300.
Key formulas and definitions
- Variance = Actual - Budget
- Production budget = Sales + Closing stock - Opening stock
- Flexible budget cost = Fixed cost + (Variable cost per unit × Actual units)
- Planned profit = Budgeted sales - Budgeted costs
Worked examples
1. Budgeted sales $120k, actual sales $112k. Find the variance and say if it is favourable.
112 - 120 = -8, so $8k below budget. Sales lower than budget is unfavourable.
2. Budgeted cost $80k, actual cost $76k. Find the variance.
76 - 80 = -4. $4k below budget; for cost, lower is favourable.
3. Sales budget 900 units. Wanted closing stock 100, opening stock 150. Find the production budget.
900 + 100 - 150 = 850 units.
4. Flexible budget: fixed cost $2,000, variable $5 per unit. Actual output 1,200 units, actual cost $8,300. Find the real overspend.
Flexed budget = 2,000 + 5 × 1,200 = 8,000. Overspend = 8,300 - 8,000 = $300 (unfavourable).
Common mistakes
- Calling every variance bad. Lower cost than budget is favourable.
- Comparing actual with a static budget when activity changed. Use a flexible budget.
- Making the production budget equal to the sales budget. Adjust for stock.
- Setting the budget without asking the managers who must meet it.