5.2 Analysing financial performance Flashcards
Budget
A budget is a financial plan.
Purpose of budgets
- Provide a targe for entrepreneurs and managers
- Basis for late assessment of the performance of the business
Income budget
The forecasted earnings from sales, sometimes called a sales budget.
Expenditure budget
Expected spending of a business.
Profit or loss budget calculation and its meaning
Calculated by subtracting forecast expenditure from forecast sales income
Forecasted sales income - forecasted expenditure
Loss = Adverse
Profit = Favourable
The 3 stages of setting budgets
Stage 1: Prepare income budgets
Stage 2: Construct expenditure budgets
Stage 3: Forecast profit or loss by comparison of income and expenditure
Why do businesses set budgets?
- Essential element of a business plan
- Banks would be more likely to grant a loan with this form of financial planning
- Help business decide whether or not to go ahead with a business idea
- Helps with pricing decisions
Difficulties of setting budgets
- No historical evidence available to a business (new or early)
- Entering a new market will not provide information or trading records
- Business may lack experience to estimate/ forecast costs
- Competitors may respond by cutting prices = affects the sales income = expenditure on promotion may have to increase
Variance analysis
The study by managers of the differences between planned activities in the form of budgets and the actual results that were achieved.
When does a positive (favourable) variance occur?
When costs are lower than the forecasted
OR
When profit or revenue is higher
When does a negative (adverse) variance occur?
When costs are higher than expected
OR
Revenues are less than anticipated
Possible responses to positive variances
- Increase production if prices are rising
- Reduce prices if costs are below expectations and the business aims to increase its sales
- To reinvest into the business or pay shareholders higher dividends if profits exceed expectations
Possible responses to negative variance
- To reduce costs (e.g. buying less expensive materials)
- Increase advertising in order to increase sales of the product and revenues
- Reduce prices to increase sales (relies on the elasticity of price)
Benefits of budgets
- Targets can be set for each part of a business
- Inefficiency and waste can be identified: appropriate remedial action can be taken
- Makes managers think about the financial implications of their actions
- Managers focus more about the financial implications of their actions
- Improves financial performance by preventing overspending
- Can help improve internal communication
- Delegates or devolved budgets can be used as a motivator: giving employees authority
Drawbacks of budgets
- Operation of budgets can become inflexible: sales may be lost if the marketing budget is followed when competitors implement major promotional campaigns
- Budgets have to be accurate to have any meaning
