What budgets are and why businesses use them
Types of budgets: revenue, cost, profit, cash flow
How budgets are set: incremental vs zero-based budgeting
Variance analysis: identifying and interpreting favourable vs adverse variances
Responding to variances: corrective action and management by exception
Limitations of budgeting as a management tool
A budget is a financial plan — a target expressed in monetary terms for a future period
It is NOT a record of what happened (that's management accounts) — it's a PLAN of what should happen
Planning — forces managers to think ahead and anticipate resource needs
Coordination — aligns departments so marketing, production, and finance all work toward the same targets
Control — provides a benchmark; variances flag problems early before they escalate
Motivation — clear targets can drive performance, especially when linked to bonuses
Communication — translates strategy into concrete financial targets for each team
Budgets cascade from corporate objectives → departmental targets → individual targets
Example: corporate target of 15% profit growth → marketing budget set for revenue growth → production budget for cost reduction
Target level of sales income. Drives all other budgets.
Maximum allowable spending for each department or activity.
Revenue budget minus cost budget. The overall financial target.
Monthly cash inflows vs outflows — critical for liquidity management.
Spending plan for long-term assets (machinery, buildings).
Consolidated summary of all budgets — the overall financial plan.
Take last year's budget and adjust by a fixed % (e.g. +3% for inflation)
Pros: quick, simple, predictable
Cons: perpetuates inefficiency; doesn't challenge existing spend
Example: school budgets, government departments
Every line item starts from zero — every spend must be justified from scratch
Pros: eliminates waste; forces fresh thinking
Cons: time-consuming; can create political battles
Example: P&G used ZBB to cut £1bn+ in costs (2017)
Top-down: senior management sets targets and hands down — fast, aligned, but demotivating
Bottom-up (participative): department managers build their own budgets — motivating, more accurate, but slow and can lead to "budget padding"
Variance = Actual figure − Budgeted figure
Favourable (F) — actual is better than budget (higher revenue OR lower cost)
Adverse (A) — actual is worse than budget (lower revenue OR higher cost)
| Item | Budget £000 | Actual £000 | Variance £000 | Type |
| Revenue | 500 | 530 | +30 | FAV |
| Labour cost | 120 | 135 | +15 | ADV |
| Materials | 80 | 72 | −8 | FAV |
| Overheads | 60 | 60 | 0 | — |
| Profit | 240 | 263 | +23 | FAV |
Revenue variance: actual £530k > budgeted £500k → FAV. Labour: actual £135k > budget £120k → ADVERSE (cost overshoot).
For revenue: Actual > Budget = Favourable (more sales than expected)
For costs: Actual > Budget = Adverse (spent more than planned)
Be careful — the sign alone doesn't tell you whether it's good or bad. Context matters.
Higher demand than forecast · Successful promotion · Cheaper raw material prices · Better staff efficiency
Lower demand · Increased competition · Supply chain cost rises · Staff absence · Poor budget setting
Sometimes variances reflect bad budgeting, not bad performance
An "adverse" variance on sales may mean the budget was unrealistically optimistic
Always investigate the cause before judging performance
Managers focus time on significant variances only — not every minor difference
Set a threshold (e.g. ±5%) — only variances outside this trigger investigation
Makes management more efficient — attention goes where it's most needed
Adverse revenue: increase marketing spend, revise pricing, target new segments
Adverse labour cost: investigate causes — overtime, low productivity, unexpected demand?
Adverse material cost: renegotiate with suppliers, find alternative materials, review wastage
Favourable variance: also investigate — may indicate underperformance (e.g. cost saving = quality cut?)
If the external environment changes dramatically (pandemic, new competitor), the budget may no longer be valid
Rolling budgets: updated every month for the next 12 months — more flexible than fixed annual budgets
Based on forecasts — inherently uncertain, especially in volatile markets
A budget is only as good as the assumptions behind it (GIGO)
Long time horizons (annual budgets) make forecasts especially unreliable
Budget padding: managers overstate costs/understate revenue to make targets easier to hit
Short-termism: pressure to hit this year's budget → underinvestment in long-term R&D
Gaming: spending unnecessary budget in December to "use it up" before year-end reset
Tunnel vision: focus on budget numbers at expense of strategic priorities
"Budgets are an essential planning and control tool, but their value depends entirely on the quality of forecasting and whether managers engage with them honestly rather than treating them as targets to be gamed."
A profitable business can run out of cash — the timing of inflows and outflows matters
Revenue is recognised when earned; cash arrives when paid (often 30–90 days later)
Many profitable businesses have failed through poor cash management (overtrading)
| Item | Jan £000 | Feb £000 | Mar £000 |
| Cash inflows | 80 | 90 | 110 |
| Cash outflows | 95 | 85 | 100 |
| Net cash flow | −15 | +5 | +10 |
| Opening balance | 30 | 15 | 20 |
| Closing balance | 15 | 20 | 30 |
January shows a negative net cash flow — but the opening balance covers it. A business must ensure closing balance never goes negative.
A firm budgeted for sales of £400,000 but achieved actual sales of £360,000. It budgeted for costs of £250,000 but spent £230,000. What is the profit variance and is it favourable or adverse?
Which of the following is the MAIN advantage of zero-based budgeting (ZBB) over incremental budgeting?
A manager's cost budget is £50,000. Actual costs were £44,000. Which statement is CORRECT?