Importance of Budgets for Organizations: Planning, Motivation, Resource Allocation, and Control

1. Chapter 3.9 - HL budgets

2. By the end of the chapter you should be able to . . . • Explain the importance of budgets for organization • State the difference between cost centers and profit centers • Analyze the role of cost centers and profit centers • Calculate and interpret variances • Analyze the role of budgets and variances in strategic planning

3. Introduction • Budget – a quantitative financial plan : • Estimates revenue and expenses • Covers a specific future time period • Help to set targets, and are aligned with the objectives of the business • Budget holder • Responsible for ensuring that the budget allocations are being met

4. Importance of Budgets for Organizations • Planning – setting targets, help to provide direction • Motivation – those who have budgetary control feel empowered • Resource Allocation – help to prioritize how resources are spent • Coordination – brings departments together to work for a common purpose • Control – A tool used for monitoring and evaluation

5. Cost and Profit Centers • Cost Centers – parts of the business where costs are incurred and recorded. • By department – finance, production, marketing, etc. • By product – if a business produces multiple products, can keep of costs by product • By geographic location – used by a business who has locations in multiple parts of a country or in the world

6. Profit Centers • A part or section of a business where both costs and revenues are identified and recorded • Allows a business to calculate how much profit each center makes • Enable a business to make comparisons between sections of the business • The role of profit centers • Aids decision making • Better accountability • Tracking problem areas • Increasing motivation • Benchmarking

7. Problems of Cost and Profit Centers • Indirect cost allocation – advertising, rent, insurance, difficult to allocate • External factors - factors a business can’t control, such as competition, affect cost and profit centers • Center Conflicts – if performance in centers is compared, it could lead to unhealthy competition, which isn’t good for the business • Staff Stress – managing a cost or profit center can be stressful, and can lead to demotivation

8. Variance Analysis • Variance – the difference between the budgeted figure and the actual figure • Usually calculated at the end of a budget period once actual amounts are determined • A budgeted control process • Variances can either be favorable or adverse • Favorable – when difference between budget & actual is financially beneficial to firm • Adverse – when difference between budget & actual is financially costly to firm

9. Examples – page 243 • Table 3.9.1 • Calculating Variances • Solution

10. Role of budgets & Variances in Strategic Planning • Strategic Planning – an organization’s systematic process of defining its future direction to determine how a business will allocate the resources • Advantages of using budgets and variances • Help to control revenue and expenses • Budgets provide realistic targets • Budgets help to coordinate business departments • Budgets should be set based on SMART criteria • Variance analysis compares actual performance to budgeted performance • Variance analysis help to detect causes of deviation • Variance analysis provides an objective way of appraising budget holders

11. Limitations of budgets & strategic planning • Inflexible budgets; don’t take into account changes to the external environment • If there are significant differences in budget v. actual, the budget may lose its importance • Budgets not look into the future, and may be too short-term • Highly underspent budgets may result in unjustified or wasteful spending • If the budget setting process doesn’t include key people, it can result in resentment

12. Chapter Wrap-up • Revision checklist – page 245 • Practice Question KJC Limited – page 246