Financial Performance Analysis (AQA A-Level Business): Revision Notes
Budgets and Cash-Flow Forecasts
What is a budget?
A budget is a financial plan that provides a target for business owners and managers. It serves two key purposes: first, it sets out what the business aims to achieve financially, and second, it creates a benchmark against which actual performance can later be measured.
For a budget to be truly useful, it needs to have a specific purpose and must include clearly defined targets. The level of detail in a budget should be agreed through discussion with everyone involved. When budgets are used as a way to motivate staff, it's important that the people responsible for meeting the budget play an active role in creating it.
Structure of budgets
Budgets typically consist of three interconnected components: income budgets, expenditure budgets, and profit (or loss) budgets. Each serves a distinct function in the financial planning process.
Income budgets
An income budget forecasts the earnings a business expects to receive from sales. This is sometimes called a sales budget.
For a newly established business, income budgets are based on market research findings, as there's no previous trading history to refer to. Established businesses can draw on their trading records to make more accurate predictions about future sales.
Income budgets are usually prepared on a monthly basis, building up to create an annual forecast for the next financial year.
Expenditure budgets
An expenditure budget sets out the expected spending of a business, broken down into various categories. The specific categories used will depend on the type of business.
For example, a manufacturing business might include sections for 'raw materials' or 'components', whereas a service business may not need these categories. Common expenditure categories include wages and salaries, marketing and administration costs, interest payments, and other operating expenses.
Profit (or loss) budgets
Profit or loss budgets are calculated by subtracting forecast expenditure (costs) from forecast sales income:
Depending on the balance between income and expenditure, the budget may predict either a profit or a loss.
It's quite normal for new businesses to forecast a loss during their first trading period, as they often face high initial costs and take time to build up their customer base and sales revenue.
Example: Viking Boards Ltd
Worked Example: Three-Month Budget Analysis
The table below shows a three-month budget for Viking Boards Ltd, a newly established manufacturer of surfboards:
| Item | April (\£) | May (\£) | June (\£) |
|---|---|---|---|
| Cash sales | 10,215 | 15,960 | 17,500 |
| Credit sales | 0 | 0 | 4,125 |
| Total sales | 10,215 | 15,960 | 21,625 |
| Purchases of raw materials and components | 19,500 | 14,010 | 15,550 |
| Interest payments | 1,215 | 1,105 | 1,350 |
| Wages and salaries | 3,000 | 2,850 | 2,995 |
| Marketing and administration | 2,450 | 2,400 | 2,450 |
| Other costs | 975 | 1,100 | 1,075 |
| Total costs | 27,140 | 21,465 | 23,420 |
| Profit/(loss) | (16,925) | (5,505) | (1,795) |
Key observations:
- The business forecasts losses in all three months, shown in brackets
- The losses are decreasing over time (from \£16,925 to \£1,795) as sales grow
- Sales revenue is increasing steadily from \£10,215 in April to \£21,625 in June
- This pattern is typical for a start-up business
Exam tip: In an examination, you might need to complete budgets by inserting missing figures or recalculate figures. For example, you may need to work out profit by subtracting total costs from total sales.
The process of setting budgets
Setting budgets follows a logical three-stage sequence, with each stage building on the previous one.
The Three-Stage Budget Process:
Stage 1: Prepare income budgets The first step is to forecast sales income. For new businesses, this relies heavily on market research data. Established businesses can use their trading records as a foundation, adjusting for expected changes in market conditions.
Stage 2: Construct expenditure budgets Once income projections are in place, the business can estimate its expected costs. At this stage, potential suppliers may be contacted to obtain accurate information about the costs of materials and other inputs.
Stage 3: Forecast profit or loss The final stage involves comparing projected income against projected expenditure to calculate the expected profit or loss. This gives the business a complete picture of its anticipated financial performance.
Why businesses set budgets
Businesses invest time in creating budgets for several important reasons:
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Business plan requirement: Budgets are an essential part of any business plan. Banks and other lenders are unlikely to provide finance without seeing this type of detailed financial planning.
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Decision-making tool: Budgets help businesses evaluate potential opportunities. If a budget shows that a new business idea would result in significant losses with little chance of improvement, the idea may be abandoned before money is wasted.
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Pricing decisions: When budgets forecast a large loss, businesses may decide to adjust their pricing strategy to improve their financial prospects. This helps ensure the business can remain viable.
Difficulties of setting budgets
Those responsible for creating budgets often face several challenges:
Common Budget-Setting Challenges:
Lack of historical evidence: New businesses, or existing businesses entering new markets, have no trading records to guide their forecasts. This makes it difficult to predict sales income accurately or understand how costs and revenues will fluctuate throughout the year.
Forecasting costs: Estimating costs can be problematic, particularly when a business lacks experience with certain expenses. Costs for raw materials or wages may be difficult to predict with accuracy, especially if prices are volatile.
Competitor actions: Rival businesses may respond to a company's actions in unexpected ways. For instance, competitors might launch major promotional campaigns or cut prices heavily. This can significantly reduce the forecast sales income, making the original budget unrealistic. As a consequence, spending on promotion may need to increase, pushing up costs.
Exam tip: Remember that financial information given in examination questions may be a forecast rather than actual data. You should approach it with caution, particularly if you suspect the quality of the market research was poor.
Variance analysis
What is variance analysis?
Variance analysis is the process by which managers study the differences between planned activities (shown in budgets) and the actual results that were achieved.
As the time period covered by the budget unfolds, actual performance data becomes available. Managers can then compare these real figures with the budgeted figures to calculate and examine variances.
Calculating variances
A variance is simply the difference between the budgeted figure and the actual figure for any given item:
Worked Example: Calculating Variances
The table below shows how to calculate variances by comparing budgeted and actual figures:
| Item | Budget figure (\£) | Actual figure (\£) | Variance (\£) |
|---|---|---|---|
| Sales revenue | 39,500 | 42,420 | 2,920 (favourable) |
| Fixed costs | 9,500 | 9,500 | 0 |
| Wages costs | 10,450 | 11,005 | 555 (adverse) |
| Food and drink | 8,475 | 9,826 | 1,351 (adverse) |
| Other costs | 5,300 | 6,000 | 700 (adverse) |
| Total costs | 33,725 | 36,331 | 2,606 (adverse) |
| Profit/loss | 5,775 | 6,089 | 314 (favourable) |
Analysis:
- Sales revenue variance: (favourable)
- Wages costs variance: (adverse)
- Overall profit variance: (favourable)
Positive (favourable) variances
A positive or favourable variance occurs when costs are lower than forecast, or when profit or revenues are higher than expected.
In the example above, sales revenue shows a favourable variance because actual sales (\£42,420) exceeded the budgeted amount (\£39,500) by \£2,920. The profit also shows a favourable variance, as the actual profit (\£6,089) was \£314 higher than budgeted.
Negative (adverse) variances
A negative or adverse variance arises when costs are higher than expected, or when revenues are less than anticipated.
In the table, wages costs show an adverse variance because actual wages (\£11,005) were \£555 higher than budgeted (\£10,450). Similarly, food and drink costs and other costs both show adverse variances.
Using variances to inform decision-making
Variances provide valuable information that can guide management decisions, but they must be interpreted carefully.
Responding to positive variances: When a business experiences favourable variances, several options are available:
- Increase production levels if rising prices are generating higher profit margins
- Reduce prices if costs are below expectations, potentially boosting sales volume
- Reinvest extra profits back into the business or distribute higher dividends to shareholders if profits exceed expectations
Responding to negative variances: When adverse variances occur, businesses might consider:
- Reducing costs by purchasing less expensive materials or finding cheaper alternatives
- Increasing advertising expenditure to boost sales of the product and improve revenues
- Reducing prices to increase sales volume (though this only works effectively if demand is price elastic)
A note of caution: Neither a favourable nor an adverse variance automatically means everything is going well or badly. An adverse variance doesn't necessarily indicate that the people responsible have been inefficient.
For example, a favourable production material variance might result from using lower-quality raw materials, which could manifest as a drop in sales later. Similarly, an adverse cost variance may occur simply because sales were higher than forecast, requiring the business to incur extra costs to meet increased customer demand.
Exam tip: When analysing variances, look for relationships between different items. If sales revenue shows a negative variance, it's reasonable to expect that variable costs might show a positive variance. If they don't, it suggests profits will have a negative variance.
The value of budgeting
The usefulness of budgeting can be assessed by weighing up both its advantages and disadvantages.
Benefits of budgets
Budgets offer numerous advantages to businesses:
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Target setting: Budgets allow managers to set targets for each department or division of a business. This makes it easier to identify which parts of the business are contributing most effectively to overall performance.
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Identifying inefficiency: By comparing actual results with budgeted figures, managers can spot areas of waste or inefficiency and take appropriate corrective action.
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Financial awareness: Creating budgets makes managers think carefully about the financial implications of their decisions. This helps focus decision-making on achieving business objectives.
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Financial control: Budgeting improves financial control by helping to prevent overspending, as managers are expected to work within their allocated budgets.
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Improving communication: The budgeting process can enhance internal communication, as different departments need to coordinate their plans.
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Motivation: When budgets are delegated or devolved to individual managers, they can serve as a powerful motivator. Giving employees authority and the opportunity to fulfil higher-level needs can boost morale. At the same time, senior managers retain overall control by monitoring budget performance.
Exam tip: When answering questions about the value of budgets, avoid writing only about preventing overspending. Make sure you can present a wider range of arguments about their benefits.
Drawbacks of budgets
Despite their benefits, budgets also have some limitations:
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Inflexibility: Budget operations can become too rigid. For example, sales opportunities may be lost if the marketing budget is strictly adhered to when competitors launch major promotional campaigns. Sometimes flexibility is needed to respond to changing circumstances.
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Accuracy requirements: Budgets must be accurate to have real value. Wide variances between budgeted and actual figures can demotivate staff and waste the resources that were used to prepare the budgets. Inaccurate budgets provide poor guidance for decision-making.
Remember!
Key Points to Remember:
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A budget is a financial plan that sets targets and provides a basis for assessing performance.
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Budgets consist of three parts: income budgets (forecast sales), expenditure budgets (expected costs), and profit/loss budgets (income minus expenditure).
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Variance analysis compares budgeted figures with actual results. Favourable variances indicate better performance (lower costs or higher revenues), while adverse variances suggest worse performance.
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Variances must be interpreted carefully – they don't automatically indicate success or failure, and you should look for relationships between different variances.
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Budgets provide many benefits (target setting, identifying waste, financial control, motivation) but also have drawbacks (inflexibility, need for accuracy).