Budgeting Flashcards
Business Analysis and Strategy
What is budgeting
A budget is a financial plan for the future;
without such a plan, businesses and individuals often get into financial trouble.
What is sales revenue budget
Set out a business’ planned revenue from selling its products. Important information
includes expected level of sales and the likely selling price of the product.
What is expenditure budgets
set out a business’ planned
expenditure on labour, raw materials, fuel and other items essential for production.
What are the pros of budgeting
*A means of controlling income and expenditure.
* Regulate the spending of money and highlight losses, waste and inefficiency.
* They act as a review and allow time for corrective action to take place.
* They allow delegation without loss of control – subordinates can be set their own targets.
* They help in the co-ordination of a business and improve communication between different sections of the business.
* Budgets provide clear targets to be met and should help employees to focus on costs.
* Can act as a motivator for staff if budget is met.
What are the cons of budgeting
*They can be time consuming for managers in small businesses; especially for those who are not particularly numerate.
* Some personnel can resent having to meet budget targets that they have had no part in constructing. Poor motivation and missed targets can result.
* If the actual figures are very different from the budgeted ones the budget can lose its significance.
* The budget must not be too inflexible as business opportunities might be missed.
* Poorly constructed budgets can lead to poor decision making.
What is a variances
A variance is any unplanned change from the
budgeted figure. They occur when an actual figure for sales or expenditure differs from the budgeted figure. Variances can be favourable (F) or adverse (A).
What is a favorable variance
A favourable variance exists when the difference between the actual and budgeted figures will result in the business enjoying higher profits than shown in the budget. For example, when:
– expenditure is less than expected
– revenues are higher than expected.
What is adverse variance
An adverse variance occurs when the difference between the figures in the budget and the actual figures will lead to the business’ profits being lower than planned. For example, when:
– expenditure is higher than expected
– revenues are lower than expected.
Reasons for changes in variances
*economy is in a recession, so people are spending less
* a competitor brought out a new product
* raw material costs may have fallen
* new/cheaper suppliers may have been found
* employees may have been better trained/motivated
* fewer employees may have been employed to produce the same output.
What is zero budgets
It involves managers starting with a clean sheet
where they must justify all expenditure. This does the following:
* improves control
* helps with allocation of resources
* limits the tendency for budgets to increase annually with no real justification for the increase
* reduces unnecessary costs
* motivates managers to look at alternative options.
Reasons for changes in the variances
Favourable sales variances might be caused by numerous factors, including:
* an effective bonus scheme for salesmen
* a successful advertising campaign
* favourable weather
* the demise of a competitor.
Adverse sales variances might be caused by several factors, including:
* the successful activities of competitors
* they may have lost an important contract
* ineffective advertising
* logistical problems that meant that stock did not arrive with the customer on time
* bad weather
* general economic conditions (recession)
* changes in consumer tastes.
Favourable cost variances might have been caused by several factors, including:
* employees may have been better trained/motivated leading to improved labour productivity
* reduced costs of imported components due to a strengthening of Sterling
* raw material costs may have fallen.
Adverse cost variances might have been caused by several factors, including:
* a strike by employees
* bad weather in the growing region for crops such as sugar or coffee
* a devaluation of Sterling
* unexpected price rises from suppliers.
What is depreciation
The difference between what the value was and what it is now is called depreciation. Depreciation represents the fall in the value of these fixed assets, either due to their use, due to time, or due to obsolescence.
The straight-line method of depreciation assumes that a fixed asset depreciates an equal amount to each year of its expected useful life.
What is the calculation for depreciation
original cost - residual value /expected life of the asset (years)
Example of depreciation
Calculate the annual rate of depreciation:
= (original cost – residual value) / life expectancy
= (10,000-2,000) / 4
= £2,000
Calculate the yearly value of the vehicle:
= after 1 year (£10000 - £2000) = £8,000
= after 2 years (£8000 - £2000) = £6,000
= after 3 years (£6000 - £2000) = £4,000
= after 4 years (£4000 - £2000) = £2,000
Why is it important for businesses to depreciate their assets ?
*It is essential for businesses to depreciate the value of their machinery, because otherwise the true value would not be reflected.
* Over time machines become worn out and obsolete. If they were valued in the business’
books at their cost price it would give a false picture of their true worth and it would cause the business in general to be overvalued.
* If it was known that the business was window-dressing its accounts in such a way, it
would affect the business’ reputation and may affect their ability to borrow money.
* By depreciating the value of their machinery, the business is in a better position to appreciate its real value and hence the need for putting money aside in order to purchase replacement machinery in the future.
* There is also a legal requirement to devalue fixed assets in order to reflect their true worth.
What is price elasticity of demand (PED)
Measures the sensitivity of demand to a
change in price. Price elasticity is always negative as the increase in price will lead to a fall in sales and, conversely, a reduction in price will lead to a rise in sales.
What is the formula of price elasticity of demand (PED)
Percentage change in quantity demanded / Percentage change in price
A value greater than 1 is called price elastic, whilst a value of between 0 and 1 is called price inelastic.
Price elastic
- Number is greater than 1.
- This means that a change in price will cause a more than proportional change in the quantity demanded. The level of demand is sensitive to a change in price.
- If the price goes up, the demand falls dramatically.
- If the price goes down, the demand rises dramatically.
A fall in price from P1 to P2, sees a more than proportional increase in quantity demanded from Q1 to Q2. This means that although revenue from each item sold has fallen, sales
have increased more than proportionately which means that total revenue has increased. From a business point of view, if demand for the good is elastic then revenues will increase if your price falls, so it can make sense to cut
prices.
Price Inelastic
- Number is less than 1.
- If a good has inelastic price elasticity of demand, then a change in price causes a less than proportional change in the quantity demanded.
- If the price goes up, the demand falls just a little.
- If the price goes down, the demand increases just a little.
A fall in price from P1 to P2, sees a less than proportional increase in quantity demanded from Q1 to Q2. This means that although sales have increased, the fall in revenue from each item sold results in total revenue falling. From a business point of view, if demand for the good is inelastic, revenues will fall if your price falls, so it rarely makes sense to cut prices.
Price elasticity and sales revenue
PED is important when deciding on a pricing strategy. This is because the price of a product affects sales revenue.
* If demand is price elastic, then putting up the price will lead to a fall in sales revenue. The increase in price will be more than offset by a decrease in sales. Conversely, lowering price when demand is price elastic will lead to
a rise in sales revenue. The fall in price will be more than offset by an increase in sales.
* If demand is price inelastic, a rise in price will lead to a rise in sales revenue. A fall in price will lead to a fall in sales revenue.
* Changing the price can therefore affect sales revenue. But the exact effect, and whether it leads to an increase or decrease, depends on the price elasticity.
Price elasticity and profit
*Price elasticity also affects profit. Profit is calculated as sales revenue minus costs. Costs are likely to change with sales. The more that is produced, the higher the costs.
* If demand is price inelastic, a rise in price will lead to lower sales but increased sales revenue, but the lower sales will mean lower variable costs. So, profits will increase not just from higher sales revenue but also from lower costs.
* If demand is price elastic, an increase in sales revenue can be achieved by lowering price and raising sales. But higher sales also mean higher costs. In this situation, higher profits will only occur if the increase in sales revenue is greater than the increase in costs.
Unitary Inelastic
- Number is equal to 1.
- If a good has unitary price elasticity of demand, then a change in price will cause an equal and proportional change in the quantity demanded.
A fall in price from P1 to P2 sees an equal and proportional increase in quantity demanded from Q1 to Q2. This means that although sales have increased, the fall in revenue from each item sold results in total revenue remaining the same. From a business point of view it makes sense to cut prices if increased output reduces costs as this will lead to an
increase in profits.
Price elasticity of demand
Inelastic -
* Necessities, such as water, power, petrol
and basic foods.
* Addictive goods, such as cigarettes.
* The stronger the branding, the fewer alternatives (substitutes) are acceptable to customers. Good branding can therefore make a product more inelastic.
Elastic -
* Goods that have lots of substitutes and
are in a very competitive market, such as
bread, cereals and chocolate bars.
* Luxury goods, goods that can be done
without e.g., sport cars, exotic holidays
and organic bread.
* Expensive goods that are a big
percentage of income, such as sports
cars.
what is income elasticity of demand
Measures how sensitive demand is to a change
in income.
What is the formula for income elasticity of demand
income elasticity = percentage change in quantity demanded / percentage change in income
What are the three groups of income elasticity of demand
Income elasticity of demand can be grouped into three categories:
* Normal goods – as real incomes increase, the demand for normal goods will also increase positive income elasticity that is less than 1. Examples are matches, lemonade,newspapers.
- Luxury goods – the demand for luxury goods will grow at a faster rate than the increase in real income that created the change in demand: positive income elasticity that is greater than 1. Examples are holidays abroad, health club membership, sports cars.
- Inferior goods – these are cheap substitutes of products people prefer to buy when their income is reduced (such as value line baked beans): negative income elasticity
Interpreting the results of YED
All income elasticity of demand values can be placed into one of three categories:
ELASTIC – number is greater than 1 (positive and high) – this means that a change in income causes a more than proportional change in the quantity demanded. This result usually applies to luxury goods or services. For example, if
consumer incomes decrease then this might result in a fall in cruise holidays or designer handbags.
INELASTIC – number is between 0 and 1 (positive and low) – this means that a change in income causes a less than proportional change in the quantity demanded. This result usually applies to normal goods or services. For example, if consumer income increases then this might encourage people to eat more fresh fruits and vegetables, thereby increasing the demand for these goods.
NEGATIVE – number is less than 0 (negative) – this means that if income rises then demand falls, and vice versa. If income falls then demand rises. This usually applies to inferior goods or services, where superior goods and
services are available when a consumer has the money to purchase them. Examples of this includes supermarket own brand products, such as Tesco Value Baked Beans. If consumer income increases, then people may be able to
afford Heinz Baked Beans instead. The opposite is that if consumer incomes fall, people might try to cut back on their expenditure and buy cheaper alternatives for the same type of good or service
What is the impact on revenue for changes in price (PED)
Businesses use PED and YED to calculate how much demand will change if there is a change in price or income. The resulting change in demand can lead to a change in revenue. This could have an impact on their levels of success and meeting targets.
ELASTIC DEMAND – If price falls, then businesses see a greater increase in the quantity demanded. Even though the revenue from each product sold has fallen. As the amount sold has increased more than the decrease in price, businesses will achieve higher total revenue levels. Businesses can use this information to influence lower pricing strategies. If prices were to decrease, they
would see an increase in revenue through more than proportionate sales. However, if price increases, then quantity demanded will fall more than proportionately, which leads to a fall in revenue.
INELASTIC DEMAND – If price falls, then businesses see a less than proportionate increase in the quantity demanded. Even though sales have increased, the fall in revenue from each item sold is greater than the increase in quantity sold, leading to a fall in total revenue.
PED inelastic and PED Elastic
PED Inelastic -
Increase Prices = Revenue Increases
Decrease Prices =Revenue Falls
PED Elastic
Increase Prices= Revenue Falls
Decrease Prices =Revenue Increases
If a business is producing inferior goods with a negative YED
Demand will increase during periods of recessions and economic downturns. Therefore, retailers may be advised to
advertise their value products. This may attract customers trying to survive on a tight budget.
If a business is producing an inferior good and economic growth in the long term is positive, then they should consider diversifying into producing normal goods.
If a business is producing luxury goods with YED of above 1 (positive and high), then this means it is income elastic
This means that demand will be sensitive to changes in income. High economic growth may lead to a boom in sales, but the business should be aware that this boom in sales
could come crashing to an end if the economy went into recession. Therefore, businesses should be cautious about over stretching themselves. There may also be a case to
diversify.
What is market analysis
Market analysis is concerned with collecting and interpreting data about customers and the market so that businesses adopt a relevant marketing strategy. Businesses carry out market research so that they can identify,
anticipate and ultimately fulfil the needs and wants of their customers - both existing and potential.
What is quantitative data
Quantitative data allows a business to gather and interpret data to answer questions such as:
* Does a market exist and what is the size of the market for the business’s products and services?
* What are the demographics of the target market?
* What segments exist within the target market?
* Are the segments large enough to be a worthwhile target?
* What is the level of brand awareness that exists in the target market?
* What are customers’ buying habits?
* In what ways is the target market evolving?
What is qualitative data
Qualitative data allows businesses to explore answers to questions such as:
* What are customers’ motivations when purchasing a product?
* What are customers’ views on competitor products? What was the impact on viewers’ feelings in response to a visual marketing campaign?
* How did attitudes of existing and potential customers change in response to a marketing strategy?
What is data analysis
Data analysis following the collection of data helps to informs a business’ marketing strategy. For example, data might show that disposable incomes of customers are on average falling by 2% a year (quantitative) and that brand loyalty to market leaders is declining (qualitative). Therefore, retailers might use this information to focus more on stocking unbranded goods in their stores that
offer better value for money.
What is the impact on revenue for changes in income (YED)
*Knowing the YED of a product helps a business respond to changing economic situations and allows them to plan.
* If a business knows the income elasticity of demand for its product(s) it can use this information to help develop its strategy and its product portfolio.
* Many UK businesses are likely to focus on normal and luxury products as in general terms the economy tends to grow, and incomes tend to go up. However, in times
of recession, where incomes may go down, inferior goods could be profitable for businesses as consumers may cut back on spending and look for cheaper and lower quality products.
