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Chapter 16. Using budgets. What is a budget?. A budget is an agreed plan establishing, in numerical or financial terms, the policy to be pursued and the anticipated outcomes of that policy. In Unit 1 the setting of budgets was discussed. The focus was on planning a budget.

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Chapter 16

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Chapter 16

Chapter 16

Using budgets


What is a budget

What is a budget?

  • A budget is an agreed plan establishing, in numerical or financial terms, the policy to be pursued and the anticipated outcomes of that policy.

  • In Unit 1 the setting of budgets was discussed. The focus was on planninga budget.

  • In Unit 2 the actual using of budgeting is studied. How can budgeting help the business to improve its performance?


Benefits and drawbacks of using budgets

Benefits and drawbacks of using budgets

Benefits

  • They provide direction and coordination.

  • They can motivate staff.

  • They improve efficiency.

  • They encourage careful planning.

    Drawbacks

  • They are difficult to monitor fairly.

  • Allocations may be incorrect and unfair.

  • Savings may be sought that are not in the interests of the firm.

  • They may be inflexible.


Features of good budgeting

Features of good budgeting

  • A good budget should:

    • be consistent with the aims of the business

    • be based on the opinions of as many people as possible

    • set challenging but realistic targets (be SMART)

    • be monitored at regular intervals

    • be flexible


Variance analysis

Variance analysis

  • variance analysis: the process by which the outcomes of budgets are examined and then compared to the budgeted figures. The reasons for any differences (variances) are then found.

  • favourable variance: when costs are lower than expected or revenue is higher than expected.

  • adverse (unfavourable) variance: when costs are higher than expected or revenue is lower than expected.


Calculating variances

Calculating variances

  • A variance is calculated by the following formula:

  • variance = budget figure – actual figure

  • For variance analysis, use ‘F’ for favourable variances and ‘A’ for adverse variances, rather than positive or negative numbers.

  • A favourable variance would happen when:

    • actual income is greater than budgeted income

    • actual costs are below budgeted costs

  • An adverse (or unfavourable) variance would be shown when:

    • actual income is less than budgeted income

    • actual costs are above budgeted costs


Calculating variances the golden rule

Calculating variances: the golden rule

  • The golden rule: knowing the effect a variance has on profit tells you whether it is favourable or adverse.

  • A favourable variance will mean moreprofit than expected.

  • An adverse variance will mean lessprofit than expected.


Example variance calculation income budget

Example variance calculation: income budget

  • Income budget for XYZ Ltd, April 2009


Example variance calculation expenditure budget

Example variance calculation: expenditure budget

  • Expenditure budget for XYZ Ltd, April 2009


Example variance calcualtion profit budget

Example variance calcualtion: profit budget

  • Profit budget for XYZ Ltd, April 2009


Interpreting the variances

Interpreting the variances

  • 1What factors might have caused the variances for XYZ Ltd? In small groups find:

    aTwo factors WITHIN the business that might have led to the variances in the INCOME budget.

    bOne factor OUTSIDE the business that might have led to the variances in the INCOME budget.

    cTwo factors WITHIN the business that might have led to the variances in the EXPENDITURE budget.

    dOne factor OUTSIDE the business that might have led to the variances in the EXPENDITURE budget.

  • 2Suggest two actions the business might take to improve matters.


Interpreting the variances answers

Interpreting the variances: answers

  • Possible answers include:

  • 1a

    • Successful marketing of product A.

    • Low-quality production of product B.

  • 1b

    • Adverse media publicity concerning product B.

  • 1c

    • Efficient production methods, leading to lower wastage of raw materials.

    • Workers being given a wage rise that was higher than expected.

  • 1d

  • An unexpected shortage of raw materials, leading to higher prices being charged by suppliers.

  • 2

    • Introduce new quality assurance measures for product B.

    • Investigate alternative suppliers or different raw materials.


Calculating variance income budget

Calculating variance: income budget

  • Complete the variance analysis for XYZ Ltd’s income budget.

  • The budgeted income column has been provided.

  • Actual income for XYZ’s two products were:

    • product A: 3,000 units were sold at a price of £2.70

    • product B: 6,400 units were sold at a price of £1.25

  • Income budget for XYZ Ltd, May 2009


Calculating variance expenditure budget

Calculating variance: expenditure budget

  • Complete the variance analysis for XYZ Ltd’s expenditure budget.

  • The budgeted expenditure column has been provided.

  • Actual expenditure was as follows:

    • Raw materials were 25% of the actual income.

    • Labour costs were 25p per unit (9,400 × 25p).

    • Administration and other costs were £4,200.


Chapter 16

  • Expenditure budget for XYZ Ltd, May 2009


Calculating variance profit budget

Calculating variance: profit budget

  • Complete the variances for XYZ Ltd’s profit budget, based on your variances for the income and expenditure budgets.

  • Profit budget for XYZ Ltd, May 2009


Income budget answers

Income budget: answers

  • Income budget for XYZ Ltd, May 2009


Expenditure budget answers

Expenditure budget: answers

  • Expenditure budget for XYZ Ltd, May 2009


Profit budget answers

Profit budget: answers

  • Profit budget for XYZ Ltd, May 2009


Interpreting the variances1

Interpreting the variances

  • What were the main factors that led to the variance in XYZ’s profit for May 2009?

  • Possible answers are:

    • The price increase for product A led to a small fall in demand, which led to sales revenue increasing. (Lower volume would also have saved on variable costs.)

    • The price cut for product B led to a significant rise in demand and an increase in income (but a rise in variable costs too).

    • There was a major cut in administration costs of almost 10%.

    • Although variable costs rose per unit produced, they were the same as the budget.

  • Conclusion: the main reason for the favourable variance in profit was the significant saving in administration and other costs. The price changes of both products also helped to boost income.


Using budgets follow up exercise

Using budgets: follow-up exercise

  • Complete the questions in case study 1 at the end of Chapter 16.


Chapter 17

Chapter 17

Improving cash flow


Causes of cash flow problems

Causes of cash-flow problems

  • cash flow: the amounts of money flowing into and out of a business over a period of time.

  • Firms may have shortages of cash for a variety of reasons:

    • seasonal demand

    • overtrading, arising from over-expansion

    • over-investment in fixed assets

    • credit sales

    • poor stock management

    • poor management of suppliers

    • unforeseen change, e.g. a strike

    • losses or low profits


Ways of improving cash flow problems 1

Ways of improving cash-flow problems (1)

  • There are many ways of improving cash flow. The method(s) chosen may vary according to the cause of the cash-flow problem. The AQA specification identifies five main ways of improving cash-flow problems. These are shown on this slide and the next:

    • Bank overdraft. An agreement whereby the holder of a current account in a bank is allowed to withdraw more money than there is in the account.

    • Short-term loan. This is a sum of money provided to a firm or an individual for a specific, agreed purpose. Repayment of the loan will usually take place within 2 years.


Ways of improving cash flow problems 2

Ways of improving cash-flow problems (2)

  • Factoring. When a factoring company (usually a bank) buys the right to collect the money from the credit sales of an organisation.

  • Sale of assets. This process can improve cash flow by converting an asset (e.g. property or machinery) into cash, which can then be used to ease the problem.

  • Sale and leaseback of assets. Assets that are owned by the firm are sold to raise cash and then rented back so that the company can still use them for an agreed period of time.

  • The benefits and problems of using each of these five methods of improving cash flow are discussed after the next slide.


  • Ways of improving cash flow problems 3

    Ways of improving cash-flow problems (3)

    • Some other ways of improving cash flow (not specified in the AQA specification) are listed below:

      • Careful cash management (e.g. setting aside a contingency fund for emergencies).

      • Effective debt management — chasing up customers who have not paid on time.

      • Stock management — making sure that money is not tied up in excessively high stock levels.

      • Diversifying to create a range of products that sell throughout the year.

      • Carefulbudgeting.


    Benefits of a bank overdraft

    Benefits of a bank overdraft

    • It is easy to arrange and, once agreed, tends only to need confirming on an annual basis.

    • It is very flexible, as the overdraft can be used to pay for whatever the business requires at the time.

    • Interest is only paid on the level of the overdraft that is actually used. Furthermore, interest is only paid on a daily basis.

    • Unlike with a bank loan, a firm that uses a bank overdraft does not need to provide security (collateral).


    Problems of a bank overdraft

    Problems of a bank overdraft

    • Bank overdrafts are based on flexible interest rates, so it is difficult to budget accurately — the bank may change its rate of interest.

    • The rate of interest charged on an overdraft is usually higher than that charged on a short-term bank loan.

    • Agreements to provide an overdraft normally allow the bank to demand immediate repayment.


    Benefits of short term loans

    Benefits of short-term loans

    • Bank loans are usually at a fixed rate of interest. The interest and repayment schedule is calculated at the time of the loan, so it easy for the business to know whether it can afford to repay the loan and budget for repayment.

    • The rate of interest charged on a bank loan is usually less than that charged on an overdraft, so it can be a cheaper solution to a cash-flow problem.

    • A bank loan may be set up for a long period of time, to help the firm.


    Problems of short term loans

    Problems of short-term loans

    • Interest is paid on the whole of the sum borrowed.

    • The business will need to provide the bank with security (collateral).

    • Short-term loans can often only be used for a specific, agreed purpose.


    Benefits of debt factoring

    Benefits of (debt) factoring

    • Improved cash flow in the short term.

    • Lower administration costs.

    • Reduced risk of bad debts.

    • Can encourage businesses to be cautious and careful with their provision of credit, to ensure that all debts are factored.


    Problems of debt factoring

    Problems of (debt) factoring

    • The main problem is the cost to the business, which will lose between 5% and 10% of its revenue.

    • The factoring company will charge more for factoring than it would for a loan, as there are administrative expenses involved in chasing up the debts.

    • Customers may prefer to deal directly with the business that sold them the product. An aggressive factoring company may upset certain customers, who will blame the original seller of the product.


    Benefits of sale of assets

    Benefits of sale of assets

    • Selling assets can raise a considerable sum of money, particularly in the case of a large asset such as a building.

    • If a particular asset is no longer helping towards the business’s overall success, sale of the asset will not only ease the cash-flow problem, but also enhance the overall profitability of the business.


    Problems of sale of assets

    Problems of sale of assets

    • Assets such as buildings and machinery may be very difficult to sell quickly. A business trying to make a quick sale usually has to accept a much lower price than its true value.

    • It is a fundamental principle of business that a firm should not sell fixed assets to improve liquidity, as the fixed assets enable it to produce the goods and services that create its profit.


    Benefits of sale and leaseback

    Benefits of sale and leaseback

    • This will overcome a cash-flow problem by providing an immediate inflow of cash, usually of quite a significant level.

    • A firm can be more flexible, as new and more efficient assets can be leased.

    • The ownership of fixed assets can lead to a number of costs, such as maintenance. Sale and leaseback eliminates these costs.

    • Owning an asset can distract a business from its core activity because it has to get involved with activities such as property management or organising a transport fleet.


    Problems of sale and leaseback

    Problems of sale and leaseback

    • In the long term, the firm will usually pay more in rent than it receives from its sale.

    • As a result, sale and leaseback will also reduce the value of the firm’s assets that can be used as security against future loans.

    • The business may eventually lose the use of the asset when the lease ends, as a competitor may be prepared to pay a higher rental for the lease.


    Finding the causes of a cash flow problem group exercise

    Finding the causes of a cash-flow problem: group exercise

    • Find three or four possible causes of the forecast cash-flow problems in the situation below.

    • * In quarters 2 and 3, customers will be given 6 months’ credit when they buy product A, to boost sales


    Finding the causes of a cash flow problem answers 1

    Finding the causes of a cash-flow problem: answers (1)

    • Possible causes:

      • credit given to customers of product A leading to 6 months’ delay in receiving cash

      • steadily declining sales of product B, bringing in less income

      • significant increase in wage payments in quarter 3

      • large expenditure on capital costs in quarter 3


    Finding the causes of a cash flow problem individual exercise

    Finding the causes of a cash-flow problem: individual exercise

    • Find three or four possible causes of the cash-flow problem in the situation shown below.


    Finding the causes of a cash flow problem answers 2

    Finding the causes of a cash-flow problem: answers (2)

    • Possible causes:

      • seasonal sales — dramatic fall of income in quarter 3

      • purchase of £32,000 vehicle in quarter 2

      • repayment of loan — £24,000 in quarter 3

      • large increase in raw material costs in quarter 4 has prevented recovery


    Solving cash flow problems 1

    Solving cash-flow problems (1)

    • In groups, discuss:

      • possible solutions to the cash-flow problems listed on the slide ‘Finding the causes of a cash-flow problem: group exercise’

      • possible solutions to the cash-flow problems listed on the slide ‘Finding the causes of a cash-flow problem: individual exercise’


    Solving cash flow problems 2

    Solving cash-flow problems (2)

    • Possible answer to problems (group exercise)


    Solving cash flow problems 3

    Solving cash-flow problems (3)

    • Possible answer to problems (individual exercise)


    Chapter 18

    Chapter 18

    Measuring and increasing profit


    Profit and profitability

    Profit and profitability

    • profit: the difference between the income of a business and its total costs. profit = revenue – total costs

    • profitability: the ability of a business to generate profit or the efficiency of a business in generating profit.


    Measure of profitability

    Measure of profitability

    • Two ways of measuring profitability will be considered. Both measures investigate how efficient a business is in terms of achieving a profit.

    • net profit margin: compares the profit made with the sales income of the business/branch.

    • return on capital: compares the profit made with the amount of capital invested by the entrepreneur or financial backer.


    Net profit margin

    Net profit margin

    • This ratio is calculated as follows:

    • net profit margin (%) =net profit before tax × 100sales income (turnover)

    • For example:

    • net profit = £20,000

    • sales income = £80,000

    • net profit margin (%) =£20,000 × 100 = 25%£80,000


    Interpreting the net profit margin 1

    Interpreting the net profit margin (1)

    • To assess the meaning of a net profit margin, two comparisons are usually made:

      • Comparison over time. Is the net profit margin increasing (suggesting improvements in efficiency) or decreasing (implying a decline in efficiency)?

      • Comparison to other firms or branches/divisions. These comparisons are useful because they look at the business’s success (or failure) relative to other businesses. It is much easier to make high net profit margins in some industries* than in others; this calculation avoids judgements that may be affected by this factor.

    • *These industries usually sell fewer items at higher prices, so a high net profit margin is not a guarantee of higher overall profit levels.


    Interpreting the net profit margin 2

    Interpreting the net profit margin (2)

    • What conclusions can be drawn about the net profit margins of the three companies in the table above?


    Interpreting the net profit margin conclusions

    Interpreting the net profit margin: conclusions

    • With all three companies, comparisons should be made with competitors in the same industry. This analysis assumes that the three companies are in direct competition.

    • Company A earns a consistent net profit that has increased steadily over the 4 years. In 2008, it recorded the highest net profit margin, so it is the company that appears most likely to be successful in the future.

    • Company B has been the most successful business for 3 of the 4 years, so its overall performance has been the best of the three companies. However, its net profit margin has fallen each year and the trend suggests that it is unlikely to be as successful as Company A in the future (unless there are specific, temporary reasons for 2007 and 2008 not being such good years).

    • Company C has made a consistent profit each year but it has been less profitable than the other two companies and its owners may be concerned at the relatively low levels of profit being made. However, in some competitive industries (such as supermarkets) Company C’s net profit margins are only slightly below the average.


    Return on capital

    Return on capital

    • This ratio is calculated as follows:

    • return on capital (%) = net profit × 100 capital invested

    • For example:

    • net profit = £20,000

    • capital invested = £100,000

    • return on capital (%) =£20,000 × 100 = 20%£100,000


    Interpreting the return on capital 1

    Interpreting the return on capital (1)

    • To assess the meaning of the return on capital (%), three comparisons are usually made:

      • Comparison over time. Is the return on capital increasing or decreasing?

      • Comparison with other firms or branches/divisions. Is the money invested in this business providing a better return than the money invested in other businesses?

      • Comparison with bank interest rates. The opportunity cost for many investments is the interest that could have been gained from placing the money in a bank account. As there is no real risk in this investment, the return on capital invested in a business needs to be higher than the interest rate offered by a bank.


    Interpreting the return on capital 2

    Interpreting the return on capital (2)

    • What conclusions can be drawn about the return on capital of the three companies in the table above?


    Interpreting the return on capital conclusions

    Interpreting the return on capital: conclusions

    • Company A has steadily improved and made excellent returns on capital. It is clearly the best company in which to invest.

    • Company B performed well in 2005 and 2006, but its performance became unsatisfactory in 2007 and has worsened again in 2008. Its overall return is below the bank interest rate and it is not a good investment unless the reason for its sudden decline can be discovered and put right.

    • Company C has only performed satisfactorily in one year (2008). However, it has been improving its profitability and would seem to be a better investment for the future than Company B.


    Methods of improving profits profitability

    Methods of improving profits/profitability

    • Many methods can be used. Three main methods are:

      • increasing the price

      • decreasing costs

      • increasing sales volume


    Increasing the price

    Increasing the price

    • Increasing the price will widen the profit margin. Therefore each product sold will generate more profit.

    • This strategy will be particularly effective if the product is a necessity or has no close substitutes, as customers will be willing to pay the higher price.

    • BUT…this strategy will fail if the higher price leads to customers switching to rival products or just giving up on buying the product.

    • The business must analyse the likely effect of any price increase in situations where there are many close competitors.

    • It is possible that the price rise may cause such a large fall in demand that the higher profit margin will be offset by a dramatic fall in quantity, so the overall profit may fall.

    • In situations where there are many competitors, it may actually be more profitable to cut the price.


    Price elasticity of demand

    Price elasticity of demand

    • To assess the impact of price changes on profit, an understanding of price elasticity of demand is needed. This is provided in Chapter 32.

    • After reading about price elasticity of demand, refer back to Chapter 18.

    • Price elasticity of demand will enable you to provide more sophisticated responses to questions about price changes.


    Decreasing variable and fixed costs

    Decreasing variable and fixed costs

    • Variable costs

    • If the firm can cut its variable costs, the profit margin will increase.

    • This means that each product will yield more profit.

    • BUT…if the change in costs leads to a decrease in quality (e.g. inferior raw materials) or efficiency, the demand for the product may fall.

    • Fixed costs

    • Profit will also increase if fixed costs, such as rent, are reduced.

    • BUT…not if the cost cutting leads to lower sales (e.g. locating the shop in a place that is less accessible to customers).


    Increasing sales volume

    Increasing sales volume

    • If costs and price remain the same, it is still possible to increase profits by increasing the volume of products sold.

    • A business can achieve this by a number of methods, such as:

      • increasing marketing

      • developing new products

      • improving quality

    • BUT…all of these methods will cost money.


    Numerical example background information

    Numerical example: background information

    • A business sells 500 units of a product at £10 each. Its fixed costs are £2,000 and its variable costs are £3 per unit.

    • Calculate the profit made on this product.

    • Answer

    • TR – TC = £5,000 – (£2,000 + £1,500) = £5,000 – £3,500 = £1,500

    • Research reveals the following:

      1An increase in price to £12 will lead to a fall in sales to 450 units.

      2Cheaper raw materials will reduce variable costs to £2.50 per unit.

      3A poster campaign costing £800 will increase sales by 10%.


    Numerical example exercise

    Numerical example: exercise

    • Will the changes on the previous slide increase or decrease the profit?

    • Taking each change in isolation, calculate the profit made from:

      1An increase in price to £12, which leads to a fall in sales to 450 units.

      2Cheaper raw materials, which reduce variable costs to £2.50 per unit.

      3A poster campaign costing £800, which increases sales by 10%.

    • Should the business make these three changes?


    Numerical example answers 1 and 2

    Numerical example: answers 1 and 2

    • 1TR = £12 × 450 TR =£5,400

    • FC = £2,000 TVC = £3 × 450 = £1,350TC =£3,350

    • Profit =£2,050

    • Profit increases by £2,050 – £1,500 = £550.

    • Note how some of the increase in profit has come from lower variable costs because fewer products are made.

    • 2TR = £5,000 FC = £2,000 TVC falls to 500 × £2.50 = £1,250

    • profit = TR – TC = £5,000 – (£2,000 + £1,250) = £5,000 – £3,250 = £1,750

    • Profit increases by £1,750 – £1,500 = £250.


    Numerical example answer 3 and conclusion

    Numerical example: answer 3 and conclusion

    • 3Sales volume increases by 10% from 500 to 550 units. FC increases by £800.

    • TR = 550 × £10 = £5,500VC = 550 × £3 = £1,650

    • FC = £2,000 + £800 = £2,800

    • profit = £5,500 – £1,650 – £2,800 = £1,050

    • Profit increases by £1,050 – £1,500 = –£450 (the business’s profits fall by £450).

    • Conclusion

    • The business should carry out actions 1 and 2 but not implement action 3.


    Extension work

    Extension work

    • Calculate the final profit if actions 1 and 2 only are implemented.

    • How much profit would be made if all three options were implemented?


    Other methods of improving profit profitability

    Other methods of improving profit/profitability

    • Some other methods of improving profits are noted below, but this is not an exhaustive list:

      • investment in fixed assets

      • product development

      • marketing

      • staff training

    • Note how each of the functional areas can contribute to improved profitability.

    • Can you add to this list?


    Distinction between cash and profit

    Distinction between cash and profit

    • Profit is calculated by subtracting expenditure from revenue. It is easy to assume that a profitable firm will be cash rich, but this is not necessarily true.

    • Liquidity is the ability to convert an asset into cash without loss or delay.

    • The most liquid asset that a business can possess is cash.

    • Many firms will not have their profit in the form of cash, so a high profit may not guarantee a high level of cash.

    • It is also possible for a firm to have low profits but high cash levels. For example, a business that has just borrowed a large sum of money will have high cash levels, regardless of its profit levels.


    Why a profitable firm might be short of cash

    Why a profitable firm might be short of cash

    • The firm has built up its stock levels. Its wealth will lie in stocks on shelves rather than cash.

    • The firm has given credit to its customers. Its wealth will be in debtors (people who owe money to the firm).

    • The firm has used its profit to pay dividends to shareholders or repay long-term loans; it may be short of cash.

    • The firm has purchased fixed assets, such as new machinery or vehicles.


    Measuring and increasing profit follow up work

    Measuring and increasing profit: follow-up work

    • Complete the questions in the case study on Cadbury at the end of Chapter 18.


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